(Watch the Market Week In Review video)

Share

(Watch the Market Week In Review video)

Share

(Watch the Market Week In Review video)

Share

(Watch the Market Week In Review video)

Share

And who could blame them? While the most recent sovereign debt crisis “news” in Europe seems to indicate an improving situation there are few folks that believe the challenges are completely gone. With this in mind it seems reasonable for an investor to underweight or outright avoid Europe. At the best, it seems difficult to acquire a taste for investing in Europe. But is this a reasonable course of action? Should last year’s returns drive this year’s asset allocation? ¹

Now I admit that it took me over 30 years to develop an affinity for broccoli. Even now I am far more likely to reach for a cut of meat as opposed to a healthy dose of vegetables no matter how clear the evidence is that I should always stick to a balanced diet. In many ways, asset allocation requires the exact same type of discipline. It isn’t enough to know I should follow the asset allocation my financial advisor and I agreed to. I have to invest and rebalance to my target or “policy” weights. This means that when I don’t want to buy out of favor asset classes may be when I should be doing this very thing. Just as I should pass on a little steak in exchange for my veggies so should I maintain my exposure to challenged asset classes. As the French might say, Mangez votre broccoli!

At Russell we don’t claim to have a crystal ball to always know which asset class or region will do best each year. Instead, we have a disciplined investment process that has been built over the last 76 years. That process reminds us that diversification and asset allocation may work over time. The history of this process also reminds us that usually as the Germans might say, Dieses Mal ist nicht anders.

Share

(Watch the Market Week In Review video)

Share

1. The U.S. recovery is sustainable and very mediocre, consensus at 2.5 percent to 3 percent GDP growth in 2012
2. Europe is in the middle of a relatively moderate recession, with core Europe in a mild recession and the peripheral countries experiencing depression-like conditions.
3. China’s growth rate will be near the consensus 8 percent to 8.5 percent range

I also wrote that the driving force behind future increases will be expansion of multiples. As in my previous post, again I will turn to framing the question before answering it, and will do so by talking about three potential paths for the remainder of this year.

1. The central scenario around the U.S., Europe and China remains stable throughout 2012, because nothing much happens to make the market dismiss it.
   • The key to the multiple expansion premise is the “stability” of market expectations
   • This path would maintain stability and would likely result in multiple expansion
   • The stock market likely goes up

2. The news, on balance, in the U.S., Europe and China is better than expected in one or all three countries.
   • This path would likely lead to multiple expansion
   • Stock market likely goes up

3. The news, on balance in the U.S., Europe or China is worse than expected in one or all three countries.
   • This path would lead to multiple contraction, P/E’s and stock prices fall
   • Stock market likely goes down

My view is that the central scenario is likely correct; U.S. growth looks stable and China is more likely than not to crank out the expected growth in 2012. The biggest wild card is Europe. As I have often shared with audiences, forecasting the economy and financial markets is hard enough but that difficultly pales in comparison with trying to forecast the decisions of politicians.

That said, European policy makers are now focused on managing the impact of the current recession while making progress on the massive fiscal challenges they face. The potential for market sentiment volatility around their perceived ability to thread this very fine needle remains very high.

It is with this uncertainty clearly in mind, along with a whole host of other potential threats, that we are telling clients to maintain at least their strategic allocation to equities, if not consider a modest overweight to equities. Bear in mind that risks abound, but if they were not present, neither would the possibility of returns exist.

Share

That is a heck of a run and many investors are sensibly asking where do we go from here? Can stocks go up from here and how likely is that? In order to answer these questions you need to frame them appropriately. The simplified framework I offer is in the answering of three questions:

1. What has the market already priced into in recently very good performance?
2. What would be the primary driver to a further increase in stock prices?
3. How likely is that?

What has the market priced into stocks?
No one can ever know precisely what the market has priced into it, but you can make some reasonable deductions. Our market expectation is that the three major factors that have driven global economic and market expectations since the beginning of the economic and market recovery starting in 2009 remain the areas of greatest market focus, namely:

1. The sustainability of the U.S. economic recovery
2. Europe
3. China

In terms of stock prices, we believe that current market levels reflect fair value in the following scenario:

1. The U.S. recovery is sustainable and very mediocre, consensus at 2.5 percent to 3 percent GDP growth in 2012
2. Europe is in the middle of a relatively moderate recession, with core Europe in a mild recession and the peripheral countries experiencing depression-like conditions.
3. China’s growth rate will be near the consensus 8 percent to 8.5 percent range

What would be the primary driver for higher stock prices?
Simply put, further multiple expansion will be the primary driver for higher stock prices.

It’s easy to say, but what does that mean? The global corporate earnings recovery since 2009 has been nothing short of spectacular, but we believe we are well past the point of peak earnings growth in this market cycle. Broadly, margins are at all-time highs and operational productivity leverage is largely played out. This means that future earnings growth will likely be hard yards to gain in the next few years.

How individual companies manage this will have a great deal of impact on their individual stock prices, which, incidentally, will likely lead to a continuation of the positive stock-picking active management environment that we’ve seen this year. More to the point of this conversation however, it’s likely that companies will have to hire more people to create the incremental goods and services necessary to grow.

An increase in employment creates greater confidence in the sustainability – dare we say expansion? – of economic recovery, which in turn leads people to lengthen the timeframe used to assess potential investments. Investors typically become more willing to assign greater value to future expected corporate earnings one, two or three years into the future. Because they expect economic stability, they are more confident that companies will actual achieve expected earnings in 2012 and 2013.

This virtuous circle creates the conditions for multiple, price/earnings (P/E), expansions, which are simply the price that market is willing to pay for a unit of earnings. If the market expects that future earnings growth is more likely now than before, it will likely pay a higher price for the stock. This phenomenon effectively explains why equity markets generally continue to go up even after earnings growth starts to decline. If this is what we see, it will likely lead to modest multiple expansion.

So how likely is this to occur? That’s the $64,000 question, isn’t it? I’ll try to answer that question in tomorrow’s blog post.

Share

(Watch the Market Week In Review video)

Share

There is a long history to this muddle. For decades regulators maintained a less conservative stance on transactions conducted between financial service providers and institutional investors. This was under the belief that institutional investors were sophisticated enough to understand what they were buying, and thus needed fewer regulatory safeguards compared to the retail investor.

Following the Financial Crisis of 2008 however it became evident that many institutional investors may not have understood what they were buying. A live issue for regulators when deliberating Dodd Frank² related regulations was to what degree sellers of complex financial services or instruments should be responsible for protecting the interests of their buyers. Some proposals sought to place sellers of over-the-counter (OTC) in a special fiduciary role.

Many argued that this would be too extreme, and either be impossible to implement or would precipitate an end to the market as banks and brokers withdrew. They argued that owing to the zero sum³ nature of many types of OTC trades, the counterparty cannot by definition act as a fiduciary for the sole benefit of the buyer.

The push and pull between seller and buyer responsibilities in a transaction is old and varied. The following thought experiment might illuminate the debate. We can imagine what the world would look like if either extreme – total responsibility for outcomes for sellers, or no protections whatsoever for buyers – were true in a hypothetical marketplace. If either caveat venditor (seller beware) or caveat emptor (buyer beware) were completely suspended, what would be the effect?

Caveat venditor in extremis
Let us imagine a market where consumers are absolved of all responsibility for their choices in the marketplace. If buyers could hold sellers liable in court for all undesirable outcomes, what risks or innovations would the sellers incur? On what basis would consumers express preference? What questions of meaning will they ask, what choices of significance will be made? And in such a market, on what basis would the sellers divine consumer needs?

To illustrate, take the case of a retiree who is buying a target date fund from an investment management firm. In the face of uncertainty and ultimate seller responsibility for outcomes, one could imagine the seller of such a fund not wanting to do anything that would deviate from peer behavior, or whatever the courts held as the standard of responsibility. Indeed with the distinct likelihood of negative outcomes it is questionable whether the seller would offer such a fund at all. The liability caused by poor or negative returns would likely not be worth what fees they could charge. The market, if it functioned, would function poorly with few sellers or sellers with possibly prohibitive prices, and little variance in investment offerings. Investment alternatives would inevitably start looking like insurance products.

Caveat emptor in extremis
Let us take the converse. If the sellers of goods or services are exempted of any responsibility for their product, it would also likely cause market failure. In a world where little to no care is taken for the quality of investment outcomes on the part of the seller, few if any transactions will occur. Take for example the stock exchanges and capital markets of countries where the rule of law is weak and regulations unenforced. Investors and their capital tend to shun such places, deals are left undone.

The thought experiment hopes to show that at either extreme of caveat venditor or caveat emptor, markets will function poorly. The closer that rules and regulations bring the market to the mean, with both buyers and sellers taking responsibility for their choices and actions, the more likely that a market will function.

A final observation: the CFTC final ruling announced in January seems to strike a balance between the two extremes described. To the relief of sellers whose business is to price risk, and buyers who need the risk management that swaps provide, the rules did not place sellers of OTC instruments in a fiduciary role. And so the pendulum swings. The push and pull between the responsibilities of buyers and sellers will continue.

Share

(Watch Market Week In Review video)

Share

Telecommunications is sufficiently advanced to the point of allowing us to discuss the banal in a previously miraculous setting. When one considers how information now clearly flows at the speed of light it’s easy to see how investors can convince themselves that speedy data requires speedy reactions. In other words, if we get the data faster maybe we have an advantage if we can react fast enough. Sadly, this is seldom the case for investors.

While we may get market or even economic data faster and faster every year this doesn’t often translate in to actionable events for the average investor because their goals and objectives don’t change that fast. The reason is simple – while markets change constantly (and always have) we as individuals do not. The changes that are the most meaningful in our wealth management plan (and our very life itself) are actually much slower developing.

One of the most impactful decisions we are likely to make is when to retire. We don’t typically do this in a moment’s notice based on some new data point delivered at light speed but instead over months or years with the consultation of our loved ones and likely our most trusted advisors. We slowly consider our situation and the counsel of others to arrive at a decision that we believe gives us the best outcome. As my grandmother would say “what you do to yourself means more than what others can do to you”.

Technology is great and certainly can change the way we view the world. But remember that as different as things may seem they still bear a strong resemblance to days past. It is fun to plot the lineup of my son’s baseball team as I hurtle through the sky but in the end – the outcome of the game will still be decided on the field. Don’t let your responses take you out of the game!

Share

(Watch Market Week In Review video)

Share

(Watch Market Week In Review video)

Share

Is it fair to say that the outcome of Europe, and the euro, will have a major impact on the global economy?

That’s exactly right. We think the biggest systemic risk to global markets at present is the potential consequences of European debt crisis. Though some market observers fear a scenario where a crackup of the euro zone could trigger “the next global financial crisis,” we don’t think that’s the most likely outcome. Actually, the European Central Bank (ECB) moved aggressively to implement its version of quantitative easing, known as a Long-Term Refinancing Operation (LTRO). The program went into effect at the end of 2011, and we think it significantly reduced the likelihood of a fat “left tail event,” or a European Lehman-like situation.

This ECB liquidity provision has been critical. Until late 2011, the ECB had been making only modest increases in its purchases of sovereign debt from Greece and other peripheral markets  and openly resisting calls to do more. That’s because it was feeling pressure from Germany and other core policymakers not to act as a lender of last resort or to bailout profligate members. It was also unwilling to compromise its credibility and independence. We believe the ECB must continue to get its hands dirty, since it is the only credible actor with the both ability and the resources to effectively address the current European crisis.

Even though the consequences are economic, financial and human, Europe suffers from a political problem and the solution – unfortunately – must be political as well. Given the fragility of the European banking system and the conflicting political agendas among European countries, we continue to see potential European policy errors/inaction as the single largest source of systemic risk and threat to global market sentiment. We think political leaders and the European Central Bank need to implement swift and decisive policy action to assure global investors that they won’t allow the crisis to “go Lehman.” However, we can’t help but notice that many of the recent (late 2011) market rallies were in response to moves by the International Monetary Fund and a coordinated action by global central banks led by the U.S. Federal Reserve. This observation underscores the dearth of policy leadership in Europe, and implies that there is an uncomfortably high probability for political conflict and policy errors.

In some respects, it’s like a high-stakes game of chicken. We believe the exit of a country from the euro zone – be it a unilateral withdrawal or ejection by the others – could be unthinkably and unacceptably costly for Europe and the global economy. This would almost certainly cost far more in lost output and wealth destruction than an ambitious euro rescue program. As a result, we remain guardedly optimistic that rational analyses within the euro zone will hold it together, though there will undoubtedly be many bumps and detours in the road.

Our base scenario is that we think that European Union will be successful in upgrading the current situation from a “crisis” into a “chronic condition.” That said, history has shown us that European leaders will probably need to tempt a near-death experience before they begin to implement the solutions discussed above. Things may have to get worse before they get better.

What are the implications for investing in euro-denominated securities?

Until a sustainable and credible political solution to the European crisis is crafted and implemented, we will remain highly vigilant and favor a more defensive positioning vis-à-vis Europe. This does not imply that investors should change their long-term investment strategy. Just the opposite. If and when a solution looks like it has holding power, we could see a relief rally. European equities that have justifiably borne the brunt of investor risk aversion and valuation drops may well be compelling in such a market turn.

Don’t forget, in Europe government bonds are the toxic assets. That said, there may be opportunities in European sovereign debt and corporate bonds as well. As long as current investor sentiment persists, we expect investors to episodically fly to the haven of German bunds, U.S. Government Bonds, and other strong global sovereigns. If and when we see a normalization of investors’ risk attitudes, spreads may well narrow between the highly rated sovereigns, those sovereigns currently under threat, and corporate bonds.

Share

(Watch Market Week In Review video)

Share

Many of our clients are asking about Emerging Markets, especially China. What are some of the risks and opportunities that the global Russell strategist team is keeping an eye on right now?

China is an increasingly important variable of the global economy, even though the European crisis has been grabbing most of the headlines these days. In fact, it’s important to understand that the two regions are, increasingly, closely linked. We know that an important risk for the Chinese economy in 2012 is a significant slowdown in export demand as Europe slides into a recession; this is because the two regions’ economies are much more dependent upon global trade as a percent of Gross Domestic Product (GDP) – in contrast to the USA. The importance of trade (and trade finance) was dramatically demonstrated in 2009 when the global financial crisis and the subsequent economic recession magnified the export slowdown in Asia. We believe the ongoing crisis in Europe will be important to China in 2012 for essentially the same reason. Additionally, it will likely exacerbate already tight global credit conditions as European banks restrict lending globally, and particularly in Asia, in order to maintain regulated capital ratios.

Also, China is ending a multi-year tightening cycle, which began in early 2010. This tightening cycle has been a key reason as to why Chinese equities have dramatically underperformed, up only 2.6% annualized since Sept 2009, whereas U.S. markets are up 12.4% in the same time period¹. China has been attempting to control a significant inflation problem and also to deflate bubbles in their equities and housing markets. There may also be downside risk to the consensus economic forecast for 8.0 percent GDP growth in 2012. Private property development activity in China is turning down as tighter monetary conditions reduce property demand and create financial difficulties for property development firms.

To further complicate the picture, it is important to note that China has resources and a war chest of foreign reserves. We think weaker private sector construction activity will be at least partly offset by the government’s “social housing” program to build 35 million affordable homes by 2015. And we think Chinese equities are now more reasonably priced. Forward and trailing P/E ratios are below 10² times compared to peaks of over 20 times in 2007. We think this tightening cycle is nearing an end and that, by the close of 2012 or the beginning of 2013, China could be contributing to global growth once again.

Share

(Watch Market Week In Review video)

Share

The $20 billion club consists of the 16 U.S. listed corporations that have worldwide pension liabilities of more than $20 billion. Together, they represent almost 40% of the total pension assets and liabilities of all U.S. listed corporations. The 2011 annual 10-K filings of all of these corporations have now been filed with the SEC, so we now know how things went – and it’s not pretty. The total pension shortfall for these corporations jumped from $121 billion to $173 billion.

The single biggest reason for this increase was the fall in interest rates. As rates fell (by around three quarters of one percent) the value placed on future liabilities went up. Meanwhile, asset returns were positive but did not quite cover the cost on interest on the existing liabilities. So even though these corporations made contributions to their plans of more than $20 billion (almost double the service cost of new benefit accrual), the gap between assets and liabilities grew in 2011.

Corporations have already announced substantial contributions to be made in 2012. But with the shortfall as large as it is, sponsoring corporations are likely to need to make significant contributions for several years to come, unless market conditions prove exceptionally favorable.

More details of the development of the pension assets and liabilities of the $20 billion club in 2011 is available. Download a copy of the research “Shortfalls increase for the pension world’s $20 billion club; cash contributions on the rise.”

Share

We responded by saying that our base case was, and remains, that this whole mess would end with a constructive solution – slowly and painfully – but ultimately successful in averting disaster. But as headlines and economic data worsened in the second half of 2011, it became harder to hold on for a lot of investors. Add to that, with the U.S. economy strengthening and Russell’s increase in confidence for a positive U.S. equity market return forecast in 2012, many clients were really wondering why they should be still holding non-U.S. stocks and to some degree why Russell continued to hold these stocks.

In terms of strategic asset allocation, Russell’s commitment to global asset class diversification in all asset classes is unchanged and as strong as ever. The question of “given all the risk in Europe, does non-U.S. exposure, in particular equities, make sense in the short term?” came up a lot. This is a very reasonable question to which we had an admittedly awkward answer.

What we said was, yes we think Europe is in a recession, yes the politics around this are toxic, yes Europe will likely continue to drive volatility, yes the U.S. economy is in better shape than Europe, and yes, we are more confident in the potential for positive equity returns in the U.S. than elsewhere. This seems to be a compelling case to significantly overweight U.S. stocks and underweight non-U.S. developed and emerging market stocks. Then we said what if the market chooses to believe that the threat to Europe is less than before and began to accept that perhaps people like us would eventually be proved right by a constructive solution to the liquidity and solvency challenges? We argued if that were the case we would expect the U.S. stock market would meaningfully lag the rest of the world.

It seemed too much to hope for but as it turns out, so far this year here is what we have seen:

(as of 2/28/2012)

Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Europe ex-UK led the way in the developed markets up 14.24%. The year isn’t over by a long way and the last two years have shown us the vagaries of market sentiment.

We have long shared with clients what I refer to as the “quilt” chart that shows calendar year-by-calendar-year relative performance of asset classes (chart below), and the apparently random leadership among asset classes from year-to-year. Although we spend a good deal of time trying to correctly predict which asset class will win this annual derby, we are very aware of the staggering difficulty in getting this right regularly and the virtual impossibility of being right every time. This understanding has informed our investment process and advice to clients about the perils of betting too big on this activity.

(View full Value of diversification chart as pdf)

Diversification is a powerful thing. At its most elemental diversification is recognition of the fact that no matter how confident you are in forecasting, no one knows with absolute certainty what will happen in the future. If you truly knew what was going to happen you would only purchase that asset that would go up the most in the future and you would know exactly when to sell it at its highest price point and what to buy next. You diversify, because at the end of the day you do not know what will happen. It makes for an interesting an often surprising ride, but it is never dull. Keep in mind that diversification can’t guarantee a profit or protect against loss.

The economy and markets appear to be on an inexorable path to globalization and investment strategies need to evolve to the reality that what country a company is incorporated in is becoming less and less important to its future results and stock price. We remain committed to positioning our clients in portfolios that can take full advantage of this new paradigm. That said, the other side of diversification is that if you do it right, when some elements of your portfolio are having their day in the sun, other parts of your portfolio are firmly in the shade. Recognizing and weathering this inevitable pattern is the price investors pay for our inability to predict the future with perfect clarity.

In the news: Oil and gasoline prices
With regard to more mundane issues, there is a European summit that will take place on March 1 – 2. We will highlight any noteworthy developments as a result, but as of now the market continues to be encouraged by the progress Europe has made and unconvinced that it is completely over. I would tell you that the press coverage over the last week has, for the first time in six months, pushed the immediate concern for Europe aside as it begins to focus on the threat that high oil/gasoline prices present to the economy and the stock prices. The market will always be worried about something; at least this is something new to worry about. Our response to the concerns on oil prices is that we do believe that if oil prices stay above $120 a barrel as they currently are for an extended period of time (say three months), that will cause Russell to revisit our economic growth rate forecasts and that will likely have the effect of lowering our expectations for the stock market. We view the recent rise in oil prices to this level as having two primary components: an improving global economic outlook driving increase demand for oil and the tensions with Iran and its potential impact on the oil supply. That second factor likely explains the price move to over $120/barrel and we think at this point it is unlikely that this current tension escalates to having an actual impact on supply. Therefore, we do expect that as this threat lessens, we should see oil drop below $120/barrel taking some of the pressure off of the markets. Probably to be replaced by a new threat, but as I said, it is never dull.

Share

(Watch Market Week In Review video)

Share

(Watch Market Week In Review video)

Share

(Watch Market Week In Review video)

Share

I have the good fortune to work with some of the best advisors in the United States on a daily basis and the New Year brings lots of time demands as many hosted meetings with their clients to review 2011 and look ahead to 2012. While thankfully, I am often invited to speak at these meetings the key conversation occurs between advisor and client. In other words, they are proactively making efforts to have a conversation and help make sure clients were on track for their goals.

But even in more “normal” years these meetings are very important as they form the bedrock of the advisor/client relationship. They are an excellent time to bring clients up to speed with changes in the Global markets in general and their portfolios in specific. They are also an excellent time for clients to convey any changes in their circumstances that would warrant considering changes in their portfolios.

That’s right, these meetings are a two way street between advisors and clients. The best advisors recognize this and spend most of the meeting listening to their clients because they understand that while market conditions ebb and flow, they’re often not as impactful to clients as the changes in their life. For instance, a client entering her retirement years should be far more concerned with her income than market nuances.

Even though it’s mid-January it’s not too late to have this discussion. Contact your advisor and ask for a meeting to review your situation. It’s critical to your success as an investor will likely be a welcome call for your advisor. And as for me, I hope you will be hearing from me a great deal in 2012 as we have lots to talk about!

Share

Which brings us to January. The returns we saw in January brought us much of what we forecasted for the entire year. Many clients have noted this and have asked if this meant we would see a flat market for the remainder of the year, or if we would raise our year-end S&P 500™ forecast from the 1,300 level we started the year with. This is a very fair, simple and straight forward question. Hopefully, my response here will be fair and straight forward. Unfortunately, it will not be simple.

The challenge with simple forecasts for the S&P 500 is that the rationale behind them is more important that the number. But if you’re like me, you generally remember the number more than what was said before and after the number. A number is not capable of supporting subtext, but the creation of that number is all about the subtext. In a massive over-simplification of our 2012 forecast we were, and are, basically saying “stocks prices are cheap and will likely go higher if Europe does not get in the way.” Now that they have gone higher, the question is will they go even higher or will Europe “get in the way” as it has so often over the last two years?

Clearly the market has been less concerned about Europe for the last four months, as evidenced by very strong equity performance. Is there a good reason for that optimism? The short answer is yes. From July through November, the crisis had two major areas of threat: liquidity and solvency. The last two months have been characterized by slow, meaningful progress on the issues in Europe. December brought major action by policy makers and central banks to provide enough liquidity to lower the immediate threats that a general lack of liquidity were creating for the market. January brought real progress in addressing the fundamental solvency issue.

For the last two years we have said that the solution to the Eurocrises would have three major components – essentially a three-legged stool. We think it is useful to view the January developments in Europe from that point of view.

Leg 1: Increasing the firepower available to support countries

• In the short term this means increasing the size of the “kitty”, via expansion of the European Financial Stability Facility (EFSF), European Stability Mechanism (ESM) contributions and accelerated implementation, International Monetary Fund (IMF) facilities and other support.
• The European Central Bank’s Long-Term Refinancing Operation (LRTO), which amounts to opening the discount window for three-year loans to banks at 1 percent interest. In our opinion, this significantly decreases the risk of a Lehman-type event among European banks in 2012.
• At the recent European leadership summit the treaty language establishing the ESM and making it operational by mid 2012 (not 2013 as originally discussed) has been finalized and awaits signature. Probably in the neighborhood of 500 billion Euros.
• The IMF has also called for its members to contribute more to its own firewalls
• In the short term this means increasing the size of the “kitty”, via EFSF expansion

Russell’s conclusion: As long as Italy and Spain don’t need to tap these resources, the monies available are adequate for Greece, Portugal, Ireland, and Cyprus.

Leg 2: Dealing with de-facto insolvencies

• The PSI (banks) negotiations continue as it relates to the “haircut”, or capital loss, that holders of Greek debt and are likely to conclude by mid February.
• Russell conclusion: a haircut is inevitable and an unmanaged market default of Greek debt is viewed as too risky by policy makers so a deal is likely, but will be the result of tortuous negotiations that will continue to ebb and flow. It should be noted that some bondholders view an open market default as preferable for them given their exposure to credit default swaps.

Leg 3: Creating greater fiscal discipline and integration

• The summit managed to place governments in a fiscal straight jacket going forward.
• Russell conclusion: a necessary result of successfully addressing the current flaws in the Euro, but one that is generally unpopular with many voters in individual countries. Agreeing to greater fiscal integration is agreeing to reduce the sovereignty of individual nations and that is almost always very unpopular.

We think these moves to meaningfully increase the giant pot of money available to address this issue and towards greater fiscal integration and discipline are real steps forward, but many challenges and questions remain.

• What if Spain and Italy need to tap into the giant pot of money? If that happens, “we’re gonna need a bigger boat.”
• What if the negotiations on the haircut that bondholders will take on Greek debt fail to reach a solution and an open market default of Greek debt occurs?
• What if the economic slowdown, recession, in Europe meaningfully changes the austerity and reform initiatives in place in the peripheral nations?

Like I said, subtext.

With real progress in the last two months we are more confident that equity returns will be positive and perhaps even robust in 2012, but real questions remain. That increase in confidence is leading us to slightly overweight equities in many of our Enhanced Asset Allocation (EAA) model portfolios but with the understanding that there will continue to be volatility in the position throughout 2012. But Russell is making sure our clients understand that if they make that move their success will have a great deal to do with their time horizon. If they have a short term horizon, they will have to be nimble. If they have a longer-term horizon they will need to be resilient. Of course, forecasting the markets is never certain, but we believe that overweighting equities now will prove to be a good move in the future. We also believe that even if that proves out, the journey will be painful.

I would suggest that for most of our clients, the best move may be to stick with their strategic weight in equities and fixed income. If they are currently underweight equities, consider buying more to get to their planned weight, consider an overweight but be honest with yourself about your ability to weather the “bad news” cycle about Europe that is almost inevitably going to come.

With regard to the S&P 500 target, we are leaving it at 1,300 for now. The clarity has improved around Europe but real questions remain, and revising that number up sends a message that is too blunt in our minds. Perhaps a better way of thinking of that forecast is that we are expecting the S&P to be at least at 1,300 by year’s end.

Share

(Watch Market Week In Review video)

Share

A common line of thinking in today’s market is that expansionary monetary policy coupled with a reversion to longer term averages will result in interest rates increasing. Since prices fall when rates rise, fixed income securities are a bad investment right now, or so the argument goes.

The first part of this line of thinking may be true but, contrary to the shorthand explanation of the relationship between in interest rates and bond prices, the second part of this argument may not be accurate.

Bond prices move based on changes in interest rates relative to what is implied by the forward curve not changes in an absolute sense.

Bob Collie tackles this concept in a new paper titled The Implications for Bond Prices of Changes in Interest Rates. Bob takes us through the math of how bond prices and pension liabilities can go UP even if rates rise. Bob’s paper is definitely worth the read, but I will give you a hint: This can happen if rates don’t rise more than the increase that is already priced in to today’s yield curve. This article is particularly applicable to investors who may be holding off on implementing an LDI solution based on a oversimplified logic that a rise in rates will result in a better funded position.

Share

In fact, between the Giants and the Patriots there are a total of 10 losses and in the case of the Giants, 5 teams had better regular season records. These teams faced the great adversity that every NFL season brings, and overcame by working as a team, sticking to their game plans, and after careful review making changes as needed. This is exactly what investors must do as they face the difficult markets of recent years.

Most successful investors will work with a team of team of trusted financial, legal and tax advisors.  The coordination of these advisors’ skills and the investor’s goals forms the game plan that gives each investor the best chance for success. Like coaches, these advisors have the task of evaluating market conditions and matching each client with the appropriate asset allocation and strategy designed to reach each investor’s unique goals. While it can be attractive to “do something” when markets prove challenging, we should be reminded of the way the Giants stuck with their quarterback after starting the season with two losses. Sometimes the wisest choice is to stay the course with the plan you have in place.

There are lessons to be learned from these teams and the adversity they faced this season. Consider every option carefully but remember there’s a reason your financial plan was put in place to begin with.  Because after all, accomplishing your investment goals are every investor’s ultimate “Big Game” victory!  Now, about my Dallas Cowboys©…

Share

(Watch Market Week In Review video)

Share

(Watch Market Week In Review video)

Share

(Watch Market Week In Review video)

Share

(Watch Market Week In Review video)

Share

Our central scenario, which assumes the worst outcome in Europe is avoided, is for a moderate recovery in the global economy and a volatile, yet ultimately slightly positive, equity market outcome. This is not just our view, but an emerging consensus around the world. Indeed, this mediocre-at-best and potentially very-bad-at-worst scenario has solid groundings in any serious global analysis. Yet it is often good practice, when facts and their interpretations all seem to line up on the same side of a market issue, to look at the contrarian possibilities. What could surprise us on the upside?

• Any serious considerations of the positives must necessarily start with the presumption of an effective, durable European resolution. A case can be made that Europe’s problems in the short-term – namely access to funds for solvent but illiquid entities, to buy time for effective structural solutions to be developed – isn’t that far away. This would set the stage for global investors to return to corporate and economic fundamentals.
   
• Next on the list is a steady – even if unspectacular – U.S. economic recovery in 2012. Our central forecast for the U.S. labor market (barring a European convulsion) is for job growth of nearly 200,000 per month by June 2012. Move that up a few months, and add a few thousand more jobs to the central forecast, and you have the ingredients for much improved sentiment regarding the world’s biggest economy.
   
• China, clearly in slowdown mode, could pull off a smooth landing and manage to avoid an abrupt deleveraging and credit crash.
   
• With the Chinese and U.S. engines running smoothly, the European scenario could quickly go from flame-out to full blast again, as the export machines in the core draw upon the fuel of U.S. and Chinese demand.
   
• One can see this supporting the fourth engine of global growth: the rest of the emerging market world. Commodity exports, the resumption of ready trade financing and improved investor sentiment would find its way into this segment of the market. A positive feedback loop would ensue.
   
• If stock market valuations are beaten down in early 2012, the scope for a rally will be huge. In 2009 global equities, realizing that Armageddon had been well and truly avoided, rallied nearly 25 percent through the end of the year (as measured by the MSCI AC (All Country) World Index). Active managers in all asset classes would have the chance to fill their boots with cheap, but attractive securities.
   
• This does not mean that we need to worry about bond yields soaring. Central banks will continue to take out insurance policies against deflation and make sure that the bursting to life of the four engines of global demand are not mere hiccups. Even if inflation pressures mounted, this would probably be greeted with a sigh of relief, evidence the global deflation has been avoided.
   
• Nevertheless, some normalization of yields would be expected, meaning equities-versus-government bonds would become a winning play, with credit and other assets leveraged to corporate fundamentals strengthening. This would generate returns from both spread-narrowing and attractive initial yields.

Share

Among the big four central banks, three – the Federal Reserve, the Bank of England and the Bank of Japan – have undertaken Quantitative Easing (QE) since the 2008 global financial crisis. Only the European Central Bank has maintained its short-term interest rate far enough above zero to continue to implement monetary policy through interest-rate decisions rather than balance-sheet adjustments. Quantitative Easing becomes relevant once a central bank has driven the short-term interest rate close to zero. At that point, the central bank can choose to inject the minimum amount of reserves into the banking system to enforce the near-zero short-term interest rate, or it can inject some amount beyond the minimum. This extra amount can itself be a policy choice by the central bank, and this policy step is called Quantitative Easing.

Below is a rundown of what we believe are the prospects for QE among the big four central banks in 2012:

• If the U.S. labor market fails to produce at least 150,000 jobs per month by the end of the first quarter 2012 and if the 10-year Treasury yield lingers below 2.25 percent, the Federal Reserve could well opt to convert “Operation Twist” into another round of QE by canceling the asset sale side of the equation.
   
• The Bank of England is ending 2011 under a program of QE, as it tries to weather the recession among its trading partners in the Eurozone. The minutes to the November 2011 policy meeting indicate that further QE could be necessary in 2012.
   
• The Bank of Japan faces near-record-high levels of the exchange value of the Yen, with the Yen/dollar exchange rate at 77.6 as of December 4, 2011. In a world of near-zero short-term interest rates, we think the only way for the Bank of Japan to engineer a lasting depreciation of the Yen is with additional QE.
   
• The European Central Bank still has its short-term interest rate at 1.25 percent as of November 2011, so it needs to cut the rate closer to zero before it can initiate QE. Between the Eurozone recession and the trouble that member countries, such as Italy and Spain, will likely face in placing their bonds in private hands in 2012, QE might be an essential policy step more than a choice for the ECB in the months to come.

Share

Our view on emerging market (EM) equities at the beginning of 2011 was cautious. Inflation was a significant concern for policymakers in the emerging world. Emerging market equities had moved from a significant P/E ratio discount to developed markets in the mid-2000s to near parity by late 2010. The need for policy tightening to combat inflation combined with equity market valuation that was no longer compelling suggested that emerging markets could underperform the rest of the world.

Indeed, EM equities lagged those of the developed world for the first part of 2011 when global risk markets generally fared well. EM equities have continued to stay volatile in the second part of 2011 as investors, spooked about the Eurocrisis, have retreated into risk-off mode. We don’t deny that over the long term, EM economies could perform better than developed economies. This should deliver further re-rating of EM equities. Already they are trading at nearly equal forward multiples to the developed world, and this should increase over time. The short-term questions are: how will China – the 800-pound gorilla of the asset class – fare next year, and what is the impact of the global economy on the developing world?

Our answer to the first question is relatively constructive. We acknowledge the structural imbalances building up in China, but believe that cyclical forces in 2012 will probably prevent a severe and swift (and painful) adjustment. Regarding EM’s gearing to broader global events, our view is that as long as the Euromess persists, growth headwinds and investment sentiment will restrain the asset class. If and when this cloud dissipates, the asset class – always a high beta play on the rest of the world given the higher risk premiums assigned to equity markets in emerging economies – should share fully in the relief rally and return to the normality that will result.

Our projections for emerging markets:

• The global economic consensus view is that the ongoing crisis in Europe will sap the strength of the EM asset class. We share this view: the tightening of credit globally, the knock-on effects to growth and liquidity, and sustained risk aversion will all weigh on EM.
   
• We do not believe that the likely outcome for Europe is a break-up of the single currency. Once European leaders and the European Central Bank (ECB) make this clear, the rising tide of a potential relief rally globally should raise all boats, especially EM. Things may well have to get worse before they get better, and EM may suffer during the “getting worse” phase.
   
• Although EM valuations are less attractive than elsewhere, strong fundamentals mean that the asset class may benefit from a return-to-risk appetite (providing that the European doomsday scenario does not play out). Assuming the year ends with positive momentum in the global outlook, EM will be leveraged to that view and should rise accordingly.
   
• EM credit, which has suffered in the recent flight-to-safety climate will materialize as an attractive asset class – both fundamentally and from a valuation perspective – and could challenge battered Western sovereigns for risk-free status.
   
• Central banks will join in the global policy easing, and this could also fuel a solid post-Euromess recovery. The war against inflation is almost won in most developing economies, and the room for easing is larger than in the developed world.
   
• Currency strength will still be a feature of EM currencies (and China may even target a lower RMB should exports disappoint), but lower interest rates and rising yields in the West – a byproduct of normalization – will cap rises to more agreeable levels in EM policymakers’ eyes.

Share

For Asia-ex-Japan, Russell believes 2012 will be a year of dealing with external threats after facing the internally-generated threats of inflation and overheating in 2011. The main danger for 2012 is a significant slowdown in export demand as Europe slides into a recession.

The positive news is that inflation appears to have peaked across the region. China in particular has scope to significantly ease monetary conditions. Share market valuations are attractive across the region with price-to-earnings ratios below 10-year averages and price-to-book value for the region is 1.6 times.

Asia-ex-Japan highlights:

• China is slowing and there is downside risk to the consensus economic forecast for 8.5 percent GDP growth in 2012. Private property development activity in China is turning down as tighter monetary conditions reduce property demand and create financial difficulties for property development firms.
   
• Weaker private sector construction activity will be at least partly offset by the government’s “social housing” program to build 35 million affordable homes by 2015.
   
• China’s central bank has just begun to ease monetary policy and this will likely continue in early 2012. This may also limit the extent of the Renminbi (RMB) appreciation during the coming year. There is a risk that the central bank will force the RMB lower if exports weaken significantly.
   
• China’s forward and trailing P/E ratios are now below 10 times compared to peaks of over 20 times in 2007.

Our projections for Japan:

• The rebuilding process from the March 2011 earthquake and tsunami disaster will provide a significant boost to economic activity and Japan is likely to be the only major economy to post above-trend growth in 2012.
   
• Price-to-book value for the overall Japanese market is below 1 as of November 2011 and a material portion of Japanese companies are carrying a lot of cash. This creates potential for corporate activity in the form of buybacks and mergers and acquisitions.
   
• The P/E ratio based on average earnings over the past 10 years is the lowest since the asset bubble burst in the late 1980s.
   
• Yen strength is a significant problem for the Japanese economy. Attempts so far at currency intervention have been feeble and the Yen continues to be perceived as a safe-haven currency. Yen strength reinforces the deflationary bias of the economy.

Share

As we wind down 2011 and hope to survive to the end of the year without a “Lehman-like” outcome in Europe, it is common to hear leaders in Europe warn that the continent faces its gravest moment since World War II. This, sadly, is not hyperbole. The fate of the single currency, and quite probably the European Union, is poised on a knife’s edge. It is difficult to make predictions about an issue that could be resolved – either happily or tragically – at any time or could linger for quite a while longer.

We have long explained the three-legged stool when discussing what is needed to resolve the Eurocrisis. For leg one, a central fiscal authority with much more financial “firepower” than the European Financial Stability Facility (EFSF) needs to be created. Leg two takes into account that some borrowers are effectively insolvent under current arrangements; therefore some debt restructuring will be required. The third leg recognizes that peripheral states, if they wish to remain in the Eurozone, need to reform their economies to become fiscally sustainable as well as competitive with core countries. This is a longer-term issue of economic governance in the bloc.

Supporting the three legs, the European Central Bank (ECB) will need to support illiquid, but inherently solvent entities, whether they are countries or banks. This is the pivotal issue confronting financial markets in 2012, and it will have to be resolved quite soon. Spain, France and Italy alone require close to €650 billion in new funding in 2012, much of it early in the year. Dealogic, an analytics firm in the UK, estimates that European banks require a further €144 billion in short-term funding in 2012 as of December 1, 2011. The current state of half measures cannot linger deep into the coming year.

Projections for the Eurozone:

• We believe the exit of a country from the Eurozone – be it a unilateral withdrawal or ejection by the others – would be catastrophic and ruinous for Europe and the global economy. This would cost far more in lost output and wealth destruction than even the most far- reaching and ambitious rescue program. Rational analysis therefore suggests the euro will hold together. However it cannot be entirely ruled out that the currency union could collapse.
   
• European leaders may need to come close to a near-death experience before they begin to implement the three legs discussed above. It may very well have to get worse before it gets better.
   
• The above also applies to the ECB’s approach to liquidity provision. Until now, it has been buying peripheral debt at the margins and openly resisting calls to do more. It is feeling the pressure of Germany and other core policymakers not to act as a lender of last resort and is unwilling to compromise its credibility by bailing out profligate members. This will have to change, and again, may come down to the eleventh hour.
   
• Economic growth: To discuss GDP forecasts for a multi-national economic bloc that consists of such heterogeneous conditions across the region is quite difficult. There is a strong consensus that Europe is or will soon be in recession. In those countries implementing severe austerity, “depression” is not too exaggerated a term to apply. In the result of a resolution to the crisis, core Europe at least should return to positive – albeit very weak – growth by the end of the year.
   
• Equities: Until a sustainable and credible solution to the crisis is crafted, we cannot see arguments in favor of anything but the most defensive positioning in European equities. If and when a solution is crafted that looks like it has holding power, the relief rally could be stunning; European equities have justifiably borne the brunt of investor risk aversion and valuations will be compelling in such an event.
   
• Fixed Income: As long as the current demoralizing state of affairs persists, we expect investors to continue to find haven in German bunds and those bonds of other strong European sovereigns (including those of non-Euro members.). If and when we are out of the woods, spreads should narrow between the highly-rated sovereigns and those currently under threat. The former should see prices decline as a result of normalization of investors’ risk attitudes as well as a probable increase in their own riskiness as risk across the Eurozone is in some way pooled. The latter should rally if default and/or Eurozone exit leaves the radar screen.
   
• Inflation and ECB policy: Undoubtedly, the longer the crisis persists and the worse it gets, the stronger deflationary forces will become throughout the Eurozone. Wage and asset price deflation has already begun in the periphery. As the core of the European Union begins to register decelerating inflationary pressures, we would bet on falling and low ECB rates well into 2012. We might even expect to see the ECB undertake some form of quantitative easing if the growth outlook for Europe deteriorates markedly. For the time being, while they are buying sovereign bonds on secondary markets, they are sterilizing these purchases such that the money supply in Europe is not actually increasing. If they wish to be more aggressive, it is not off the table that we may see rising expectations of QE in the Eurozone.

Share

With U.S. Gross Domestic Product (GDP) growth poised to finish 2011 at an anemic 1.7 percent on a year-on-year basis, it was a year in which little went right in an economy that still badly needs to recover from the Great Recession of 2007-09. We think 2012 will bring some improvement in economic growth.

On the affirmative side, many of the setbacks in 2011 need not repeat themselves in 2012:

1. Inflation expectations appear to be more firmly anchored near two percent than they were in early 2011. At that time, speculative bidding drove up commodity prices and fueled a temporary rise in inflation that is now falling out of the 12-month inflation numbers.
2. We can safely assume that the Japanese earthquake and the attendant supply-chain problems will not recur in 2012.
3. Libyan oil exports can only go up in 2012 after civil war took the country’s oil production off-line.
4. The debt-ceiling debacle from August 2011 will not be revisited until 2013.
5. We can only hope for policy clarity on resolution of the European debt crisis and long-term budget consolidation in the U.S.

Unfortunately, the fifth problem of policy uncertainty was the most serious impediment to a strong 2011, yet it is the most likely to continue in 2012. Call this a continuous policymaker injection of uncertainty. In fact, one could argue that policymakers never missed an opportunity to inject uncertainty in 2011, as they raised expectations for definitive measures and then continually fell short. Examples included the August 2011 debt-ceiling debacle, followed by the do-nothing budget Super Committee in the U.S. Congress. More importantly, the European “big bazooka” policy proposals in November 2011 clearly failed to contain Italian bond yields to a solvency level.

Nevertheless, economic forecasts are brighter for 2012 U.S. economic growth, even as the Eurozone experiences a shallow recession – barring a full financial meltdown in Europe. To bolster U.S. growth and to counteract the linkages that transmit economic and financial weakness from Europe to the U.S., we could see an additional round of Quantitative Easing (QE) by the U.S. Federal Reserve in 2012.

The details of our U.S. economic outlook for 2012:

• Real GDP growth of 2.5 percent on a year-on-year basis in 2012. Our central-tendency forecasts are predicated on not having a full-blown financial meltdown in Europe.
• Our baseline forecast is that Europe will have a recession in late 2011 and in 2012, but the U.S. will not be dragged into it. This scenario is the reverse of 1990 and 2001, when the U.S. entered into a recession and Europe did not. Nevertheless, the U.S. economy would not be able to hum through a European financial meltdown in the way it did through the East Asian crisis of 1997-98. The financial and economic linkages between these two economies are too great to make the U.S. impervious to a European meltdown.
• Non-farm payroll employment gains are projected to reach a plateau level between 180,000 and 190,000 jobs per month in mid- 2012. Even with this improved level of job creation, the unemployment rate is expected to fall very slowly during the year with such a small gap between the year’s jobs gains and the trend rate of increase in the labor force of about 150,000 entrants per month.
• Russell projects that the benchmark 10-year Treasury yield will climb gradually above 2.5 percent by the third quarter of 2012, and it will end the year between 2.5 and 2.75 percent. If this scenario unfolds, the U.S. economy will exit Japan-style stagnation expectations in 2012. Long-term interest rates can be too low for an economy’s well-being, with low long-term interest rates reflecting expectations of low growth, low rates of return and low inflation. One of the chief purposes behind the Fed’s two rounds of QE and “Operation Twist,” the new stimulus measure which is scheduled to end in June 2012, has been to reverse expectations of economic stagnation that lead to low long-term bond yields.
• Our outlook for inflation is that we project the all-items Consumer Price Index (CPI) will increase at an average rate of 2.4 percent in 2012. Decent economic growth globally – with the exception of the Eurozone – will support energy prices that should keep the all-items CPI increase above core inflation, which is expected to remain near the target level of 2 percent. We do not expect a repeat of speculative increases in energy prices of the magnitude that we saw in the first half of 2011.
• Equities: Russell gauges that target fair value for U.S. equities will be at 1300 for the S&P 500 Index and 720 for the Russell 1000® Index by the end of 2012. This represents about a 10 percent increase from where the U.S. market stood in late November 2011.

Share

1. Russell’s long-term outlook: Ongoing global deleveraging will continue to be the backdrop for economics, finance and politics for 2012 – and for some years to come.

   It took three decades for the developed economies to borrow too much money and it will take years to pay it back. Balance sheet recessions are typically followed by elongated, grinding and below-trend recoveries, so lowered standards of living and stubbornly high unemployment should be expected. So should lower returns and higher volatility. As “risk-less” assets take their place in the museum, discipline will be required as markets adjust to new risk realities. This will all take place against a backdrop of clashing priorities for Western democracies between the need for austerity, the need to support economic growth and the need to provide for rising outlays on entitlements. At its heart will be an intergenerational battle between the electorally numerous baby boomers and the younger generations that will be footing the bill.

2. The key risk: The second sub-prime crisis is called the Euro.

   Given the fragility of the European banking system, we continue to see potential European policy errors and inaction as the single largest source of systemic risk and threat to global market sentiment, much as we noted in our 2011 outlook.

3. A modest positive: a square-root shaped U.S. economic recovery

   The square-root-sign-shaped economic recovery has been our team’s highly-accurate U.S. economic forecast since 2009. With gradually improving news on the U.S. economy, continued strength in U.S. corporate earnings, and expanding pockets of private investment strength, we think this forecast persists into 2012. We expect slow stabilization in the housing market and glacial improvement in employment. While the fiscal situation in the U.S. is similar to Europe, the U.S. has the luxury of more time as a result of a more robust macroeconomic environment relative to Europe. We expect to see Europe as an accelerated time-lapse movie of the U.S.

4. A modest positive: The Chinese/Asian engine of growth

   Chinese authorities have just embarked on an easing cycle and we think that China will likely achieve a reasonably soft landing. Combined with other emerging-market easing, China and these emerging markets will – along with the U.S. – once again contribute as engines of growth for global GDP.

Share

As I stood there balling socks and folding shirts it dawned on me that I was doing this so I could pack quickly in the morning before my flight and still have time to wake my children and see them off to school before racing to the airport. Having packed for business trips literally hundreds of times before I have learned squaring away my laundry makes packing faster and decreases the chance of leaving something important behind.

I know exactly how long it will take me to pack and how long I need to make my flight. Like all frequent travelers I have learned that the secret to packing quickly isn’t in the willingness to do it quickly but in the willingness to prepare to move quickly. Having a spare suitcase ready to go is an old trick that works. At this moment the voice of a football coach from years ago came through loud and clear “Willing to win is not as important as willing to prepare to win”. Tortured travel and sports metaphors aside this is exactly what today’s investor should be doing.

Every day you are bombarded with “noise” about developments in Europe or the Super committee. These headlines seem to require our urgent attention and we are challenged to “do something”. While these panic induced trades are often not in our best interest they can be prevented. With a strong conversation with your trusted advisor you can prepare your reactions for events like these even if you can’t foresee them. Even if you are not swayed by headlines preparing like this can help you and your family be prepared in the case of personal emergencies.

Talk to your trusted advisor and plan your reactions for a crisis, real or imagined. Going through this lifeboat drill can help you separate events that need your attention and emotion. It will also help your advisor understand how she can counsel you in times of stress. After all, you don’t need the power of forecasting the future if you maintain the control of your reactions.

Share

(Watch Market Week In Review video)

Share

A year ago, we proposed that 2011 would grind along on the relatively flat tail of a square-root-sign-shaped recovery. We expected there to be a continued tug-of-war between headline-grabbing downside risks and the upside news of corporate earnings. The events that played out consistently confirmed our expectations.

In 2012, we anticipate this environment continuing. Volatility, due in many cases to sensational risk stories, will likely remain elevated through most of the year. Corporate earnings, particularly by U.S. companies, are set to slow after two years of outsized gains. Even so, modest profit growth will likely balance the scales on the positive side. The sum of these two factors should result in positive, albeit modest, global share market returns in 2012.

While this is the summary outlook globally, specific stories will certainly vary by region. Europe will continue to dominate negative financial headlines – and rightly so. A European recession seems inevitable but Europe’s leaders can still act to prevent financial collapse and a deeper downturn. We believe they will. In Asia, and particularly China, we expect the juggernaut of economic growth to slow noticeably, but to still deliver substantial total gross domestic product (GDP) numbers. And the U.S. strikes us as an undervalued field, both in terms of the equity pricing and overly pessimistic economic growth expectations. We will be surprised if the equity market does not cash in that value by the end of the year.

Economic indicators will also tell varied tales. We expect inflation – at least in the developed world, to remain low. Interest rates will likely remain low as well, with only slight upticks at longer durations. Volatility, on the other hand, will continue to present noisy and notable spikes. And the equity risk premium combined with the current interest rate levels appears to be signposting a low return environment.

What does all this mean for investors? It means attention to every detail about their portfolio management will matter. Every basis point earned will be hard fought. We believe regional diversification will need to be firmly in place, as the economic center of gravity will continue to shift eastward because of China and emerging markets. As traditional investments remain flat, alternatives will matter more than ever. And volatility, while it certainly brings market stress, will also bring market opportunity for dynamically-managed portfolios.

We believe that making gains this year will require an active, global, multi-strategy approach and identifying outperforming managers in every sector and region will count more than ever. Gaining access to non-traditional securities through alternatives will also be a key potential return enhancement strategy. In a world of increased volatility and lower returns, we believe a dynamic approach to investing to take advantage of opportunities as they present themselves, will increasingly become the norm for successful investors.

Every basis point earned in a 2012 portfolio will need to be well-protected through rigorous, efficient trading and implementation actions. Because while growth is possible this year – and it could happen for certain dynamic, well-positioned investors – it won’t come easy. 2012 is a year to pay attention to every penny.

Share

1. They’ve increased the amount of money they’ll spend on a European bailout.
2. They’re moving up the timeframe for spending it.
3. They’re taking the pressure off the European banking system by giving them more latitude in managing their reserves.

Ristuben says equity markets seem to be in favor of these activities, even if it is a bit of what he calls, “kicking the can down the road.” He also weighs in on positive U.S. consumer sentiment numbers.

(Watch Market Week In Review video)

Share

While perhaps not causally related, one can see the correspondence between higher prices for basic necessities and social instability in North Africa and the Middle East. The desperate self-immolation of one street vendor in Tunisia, Mohammed Bouazizi, channeled the frustration of millions who are finding it difficult to provide for their families and survive³. Governments are toppling to popular revolt, adding uncertainty to global markets. Oil prices are presently (Nov. 2011) approaching $100 a barrel.

The world has seen this before. During the Asian financial crisis of 1997-1998 the value of the Indonesian rupiah fell precipitously, driving prices up for cooking oil and other necessities. Indonesian inflation in 1998 reached 82%⁴. Riots erupted that year that helped end the 31-year Suharto government.

Going back to 1977, Egypt had its “Bread Riots” when President Anwar Sadat ended subsidies on flour, rice, and cooking oil. Hundreds of thousands protested, the government purchased its survival by responding with a heavy hand⁵.

Hyperinflation helped to end several governments in Latin America (e.g. Bolivia, Brazil, and Argentina)⁶ and though the timing is a bit early, it is often argued that the chaos of the Weimar Republic’s hyperinflation helped set the stage for the rise of the Third Reich⁷.

David Hackett Fischer, a history professor from Brandeis University, authored a book describing the long march of prices over history and notes the correspondence between inflation and profound social upheaval⁸. He observes that there were four great waves, or price revolutions, from about 1200 onward that were also times of tremendous social turmoil. These lasted from 80 to 180 years and were then followed by long periods of economic growth and relatively stable price levels.

In the time before central banks, periods of bad weather and crop failure could cause inflation. Debauching the currency in times of war was another cause. Price instability tended to hit the poor the hardest, which would lead eventually to social upheaval⁹.

Interestingly in Spain, the fleets of Spanish ships bringing gold and silver looted from the New World were instrumental in causing inflation during the colonial period. Despite the treasure flowing in, the inflation-related stress on the poor, with higher food prices decreasing nutrition and increasing susceptibility to disease, contributed to a population decline from over 8 million at the end of the 16th century to fewer than 7 million by the mid-17th century¹⁰.

The relationship between inflation and social instability may not be causal, and it is not clear that Fischer argues for economic determinism. But his history of inflation provides ample historical examples to demonstrate that where there is inflation there is trouble.

Share

Russell’s Chief Investment Officer Client Strategies Erik Ristuben talks about this good news – and some good rumors – on this week’s Russell Market Week in Review video webcast. Mark Soupiset hosts.

(Watch Market Week In Review video)

Share

Of course there has never been a risk free asset. But with the historic economic might, stability, and military power of the United States, modern finance has long considered the returns from U.S. Treasuries to be about as risk free as one could possibly get.

Things are different now. With the possibility of missed interest payments on U.S. government debt, S&P downgraded the U.S. from a AAA rating to AA last summer. Investors in U.S. Treasuries are adjusting to the reality that even U.S. government debt carries material risk.

As Russell’s Chief Economist Mike Dueker advised us to expect with the U.S. downgrade¹, capital reserve rules for many institutions were re-written so as to allow for the holding of U.S. Treasuries as Tier 1 capital anyway. Absent a sufficient pool of alternative assets, the world will simply have to shoulder a higher amount of risk in their reserve asset pool. Talk about systemic risk!

For the individual investor, a workable “risk-free” rate against which investment decisions should be compared could be that person’s home mortgage interest rate. If the market does not offer returns at an acceptable premium over a person’s mortgage interest rate (as a function of personal risk adversity), then the individual may be better off paying down the debt on their primary residence.

Of course home mortgage rates are fundamentally linked to U.S. Treasury rates. As Treasury rates gradually move up to reflect their higher risk, market returns had better be higher in order to provide a risk premium. Otherwise investors are literally better off “staying at home.” All other things being equal, this may mean less investing and less growth. Welcome to the new normal.

Share

Look at the chart below. This shows that world trade is now around 60% of global gross domestic product (GDP). That’s more than double what it was forty years ago. More and more of what Americans make is sold overseas, and more and more of what we buy is imported. The same is true of just about every nation on earth.

source: Wolfe Trahan. “It’s Hard to Decouple When Globalization Is in Full Effect.” May 17, 2010. Available on request at http://wolfetrahan.com/research/2010/05/17/

The words at the top of this blog are taken from Martin Luther King Jr.’s famous speech at the Lincoln Memorial on August 28, 1963 (“I have a dream”). Talking of the black community and the white community, he said: “…their destiny is tied up with our destiny… their freedom is inextricably bound to our freedom. We cannot walk alone.”

His words remain true today – and are true well beyond the realm of racial harmony. As we observe the growing economic significance of Asia in general and China in particular, and as we observe the euro-related struggles, we are more than observers: we are participants. China’s growth and integration into the global economy is inextricably bound to America’s prosperity. Similarly, Europe’s struggles affect us all. We all need a stable, prosperous world.

Of course, change creates losers as well as winners. If America gains two jobs in Silicon Valley but loses one in Pennsylvania, not everyone is better off. Global growth is not a simple story of everyone-wins, and we should not underestimate the challenges it creates alongside the gains. Prosperity is about everyone, not just about raising the average. As we face those challenges, let’s remember that we face them together.

Share

The good news is that we’re seeing positive economic signs and news in the U.S., even as the markets await next week’s Super Committee report on spending cuts. Like Europe, implementing $1.2 trillion in cuts isn’t going to be easy, but the U.S. — which spends too much and takes in too little — is going to have to go on a diet if it’s going to get its economy back in shape.

Russell’s Chief Investment Officer, Client Strategies, Erik Ristuben weighs in on these topics during this week’s Russell Market Week in Review webcast. Mark Soupiset hosts.

(Watch Market Week In Review video)

Share

The chart below shows Romer’s proposed linear path for nominal GDP growth, the actual path to date, and an alternative target path, all of which are expressed using natural logarithms to highlight the gaps in percentage terms. In my view, the current gap between actual nominal GDP (the bottom line) and the linear path (the top line) is a bridge too far, with a 10 percent gap to close.

Alternatively, I think a gradual rebasing of the target – essentially letting 8 percent of the nominal GDP shortfall in any quarter be omitted from next period’s target level – is a more realistic approach. Doing so makes the target path the middle line in the chart below. The rebased target implies a gap of about 5 percent at present between the target level of nominal spending and the actual level.

In my opinion, a five percent gap feasibly could be bridged and, more importantly, is likely to correspond closely with the monetary policy the Federal Reserve will implement. The Fed is neither likely to close the full 10 percent gap that Romer identifies, nor is it likely to let all past shortfalls in nominal spending growth be bygones in this era of high unemployment. Ultimately, regardless of what the Fed does with respect to announcing new objectives, I believe that an investor who follows the middle line as a guide as to when the Fed will end its accommodative policy will likely end up being much closer to the mark than an investor who follows the upper line as a guide.

Time will tell – and because of the uncertain nature of this kind of information, it could ultimately prove inaccurate – but in this unprecedented monetary policy environment investors are grasping for new ways to gauge the likely length of the Fed’s near-zero federal funds rate policy.

Share

The latter half of the week saw some relief, however, as the ECB stepped in to buy Italian bonds, and then Friday the Italian Senate approved an economic reform bill, opening the way for Premier Berlusconi to step down.

Russell’s Rachel Carroll examines the impact that the ongoing EU crisis, as well as a mixed-bag of economic news in the U.S., is having on global markets in this week’s Russell Market Week in Review video. Mark Soupiset hosts.

(Watch Market Week In Review video)

Share

(Watch Market Week In Review video)

Share

The good news out of last week is still important to keep in mind. First, Europe has shown the commitment to dedicate a great deal of money to address the issue. Not only have they identified the need to recapitalize their banks, but they also have “outlined” the manner in which they will support the financing needs of the peripheral countries. Essentially, they will subsidize the debt costs of weaker countries, perhaps by absorbing the first 20% of losses on new bonds issued. Exactly how this happens is still not known. European leaders also have reached an initial agreement with the bank bond holders on the size of the haircut that they will take on Greek debt (50%).

Meanwhile, the third leg of the stool we have discussed is that the peripheral countries have to pass austerity and policy reforms, and cracks are showing when it comes to support for sovereign debt by the peripherals and the ability – and willingness – of the peripherals to pass the necessary reforms to restore their economic competitiveness.

This week, the market is expressing its concern over two things. One is the mechanisms of support for Italian debt, and by extension, all of the peripheral countries.

Given the fact that last week’s plan talks about absorbing the first 20% of losses on future Italian debt issuance, the market is now asking the question, “if a 50% write-down is only marginally large enough for Greece to carry on, is a 20% loss really an upper boundary for Italy, and what’s the probability of a 20% write-down for Italian debt?” Consequently, Italian 10-year bond yields (without the 20% loss coverage) are going up to a level near 6.3%. It was at these levels that the European Central Bank first decided to start buying Italian debt in order to lower yields. Clarity around the support mechanisms for peripheral country debt is needed. It would be reasonable to cast Monday’s performance drop in the market as an expression of concern over this issue.

The second concern showed itself in dramatic fashion as the Greek Prime Minister, George Papandreou, suddenly announced a public referendum on the policy moves of his government over the last 18 months. His razor-thin parliamentary majority and the unpopularity of the austerity measures and the negative economic growth in Greece have created serious opposition within Greece to the bailout agreement. Papandreou made this announcement apparently without consulting other European leaders. The uncertainty of the election results and what that might mean for Greece’s willingness and ability to make the necessary changes to their economy to gain global competitiveness is refueling market concerns about the outcome to this crisis.

If Greece does not hold up its end of the bargain, what happens to the plan? How will European leaders respond?

The market is looking towards the upcoming G20 meeting later this week for more announcements that continue to put the meat on the bones of the outline European leaders presented last week. Uncertainty is always the enemy of the markets, so the solution will be found in bold action and clarity of purpose. The market is looking for our leaders to provide both in the coming weeks.

Share

Russell’s CIO, Client Strategies Erik Ristuben explains why this good news, coupled with positive economic and earnings news, should help the markets shift focus away from the daily political drama in Europe and towards fundamental economics. Mark Soupiset hosts this week’s episode.

(Watch Market Week In Review video)

Share

The European leaders–namely Merkel and Sarkozy, gave themselves the effectively self-imposed deadline of this week’s meetings to craft a plan. It would appear that the deadline created enough leverage for the leaders of the 17-nation Euro to form a response that actually has a chance of addressing the issues lying before them.

What did they agree to do? In so many words, they actually showed the blueprints for the three-legged stool that we have said will form the outline of the solution to the sovereign debt crisis:

1. They recommended expanding the EFSF (European Financial Security Fund) to up to one trillion euros, principally through the use of leverage (details to come later) of the current 450 billion euro fund.
   1. This expanded pool of money will allow the EFSF to provide subsidized financing for Greece and the other peripheral countries for some time to come.
   2. They also outlined the deadline and approach to the recapitalization of the European banking system, at a cost of roughly 110 billion euros.
2. They reached agreement with banks that hold Greek debt on the size of the haircut (decrease in the face value of bonds) they will be taking, which is approximately 50%.
3. They continue to demand that peripheral countries plan and implement austerity measures, as evidenced by the incremental commitments that Italy approved this week.

Although the only thing that we have seen is the plan–and in some areas only the broad outline at that–the commitment shown this week by European leaders has done a great deal to make a worst-case outcome even more unlikely. Earnings are solid and the outlook for risk assets is more positive than it was yesterday.

That said, this is not over.

The devil is in the European details. And because 17 different countries are involved there will be ups and downs, but perhaps the crisis is over and maybe we’ve entered the beginning of the end. Angela Merkel deserves some credit, as she has shown strong leadership in the last two weeks and as the market response has evidenced, that has been a very good thing.

Share

When my team does well it is easy to see why they are this year’s team of destiny on a rise to the championship. However, when they are struggling it’s easy to see all the weaknesses that will end the season in failure. At times like these I wonder how our team managers can make so many bad decisions. After all, baseball is a game of tendencies that are exploited though match ups determined by ever more scientific quantitative analysis.

In fact, Major League Baseball® plays 162 regular season games–enough games to provide a past performance of every imaginable pitching and hitting statistic. With these statistics in hand, we enter the postseason with the all the necessary facts to second guess a team’s manager for every decision. But we really don’t have the same information that a manager does, because all the information doesn’t appear in published statistics, such as the physical and mental health of the players. And unlike an actual manager, we don’t have a lifetime of experience making these same decisions in every conceivable situation.

Sounds like investing doesn’t it? When we track our portfolios during times of heightened stress using ever more common data (but not necessarily information) it can seem crystal clear we need to make a change. One investment should be sold and replaced with another that we think can make the difference in success. However, the same emotion that makes playoffs so much fun can wreck us. We become attached to the success of our portfolios because it is our money. Even to the point of ignoring good advice from our trusted advisors and in some cases even abandoning plans we made with careful thought in calmer times. Just like the playoff manager, we have to learn to ignore the emotion and focus on the goal.

As always, this is far easier to talk about than accomplish. However, reaching our long term goals is the ultimate championship for any portfolio. Staying focused on your long term goals can help you make the best decisions in critical times. Finally, remember that as much as we may want to make a change sometimes thoughtfully staying the course is often the best outcome.

Share

Future Impact
While many plan sponsors can wait three more months before choosing a discount rate for their year-end financial statements in hopes of a quick rise in rates, Russell believes most clients have elected to use a four month look-back period for funding purposes. This means that plans with a calendar year plan year already know what their rates are going to be for the January 1, 2012 valuation. Despite the fact that these interest rates are averaged over 24 months, the low interest rates will impact funded statuses immediately. These smoothed rates are segmented and the three segments are down 172, 106, and 25 basis points respectively compared to last year’s rates².

All of these numbers indicate that plan sponsors with ongoing benefit accruals should be budgeting now for a significant September 2012 contribution in order to avoid benefit restrictions. Absent government intervention, these contributions will be some of the largest we’ve ever seen pension funding rules require plan sponsors to make.

Share

Russell’s Chief Investment Officer, Client Strategies Erik Ristuben explains these trends and more on this week’s Market Week in Review video. Mark Soupiset hosts.

(Watch Market Week In Review video)

Share

There was hope this week, however, as Merkel and her peers announced that (stay with us here) they have a plan to have a plan by November to fix the problem. This – combined with mixed earnings news and some modest-but-positive economic data in the U.S. – has spurred the market rally that is now into its third week.

Will it continue? What should investors be paying attention to? And how does the Christmas shopping season shape up? Russell’s Chief Investment Officer, Client Strategies Erik Ristuben gets to the bottom of these topics and more on this week’s Russell Market Week in Review video. Mark Soupiset hosts.

(Watch Market Week In Review video)

Share

At that time, I thought that Operation Twist was a compromise measure to reduce the number of dissenting votes on the Committee. So going into the September FOMC meeting, I felt that if the three dissenters from the August meeting wouldn’t budge, the other members would push for another round of Quantitative Easing (QE), rather than the Operation Twist method of stimulus.

But the September FOMC meeting minutes show that only two members of the committee favored QE last month. So what does that mean?

I think of Operation Twist as the convertible ARM (an adjustable-rate mortgage that can be converted into a fixed-rate mortgage) of monetary policies. In other words, it can be converted to Quantitative Easing very readily simply by dropping the sales of short-term securities from the equation. So while the Fed isn’t signaling any inclination to implement a third round of Quantitative Easing (QE3), they’ve left the door unlocked just in case.

Through Operation Twist, the Fed is pointing to the importance of mortgage refinancing in boosting disposable income, which almost seems to be asking the Obama Administration to use its effective control of Fannie Mae and Freddie Mac to widen the scope of borrowers who could benefit from today’s rock-bottom rates. That might include borrowers who no longer have 20 percent equity in their homes at today’s depressed prices.

Ultimately, the success of Operation Twist is almost impossible to measure because it purports to aim for lower long-term interest rates, but if it succeeds at boosting the economy, long rates will also rise due to higher growth expectations. With QE, it is easier to say that the aim of the policy is to avoid Japan-style stagnation, so an increase in long rates is a sign of success.

Share

We seem to have entered a phase where every piece of news has that same topsy-turvy emotional effect on financial markets. From S&P’s notorious downgrade in August of Treasury bonds (which sparked a flight to safety…driving up the price of the bonds that had been downgraded) to the high level of interest in gold this year (special offer! 50% price increase! buy now while stocks last!) to a 28% increase over the year to June 30 2011 in foreign holdings of Japan government bonds, currently yielding around 1%,it’s all very weird out there.

A Robert Mankoff New Yorker® cartoon from way back in 1981 captures the sentiment beautifully: a news reader announces “On Wall Street today, news of lower interest rates sent the stock market up, but then the expectation that these rates would be inflationary sent the market down, until the realization that lower rates might stimulate the sluggish economy pushed the market up, before it ultimately went down on fears that an overheated economy would lead to a re-imposition of higher rates.”

At some point, things will revert to a more straightforward situation where good news is simply good and bad news is simply bad. That’s the way markets like it to be, but it’s not how it is right now.

My favorite example of an unambiguous message comes not from a beauty contest but from a violin contest, and the fourth prize in that was awarded to my friend and former colleague, Gareth Derbyshire, at a local eisteddfod (a Welsh cultural festival) in the mid-1970s. Fourth place was a remarkable achievement, because there were only three contestants. Because a top-three place would mean the right to represent the town at an upcoming regional event – and by Gareth’s own admission this was not where his true talents lay – the judges took their unusual step in order to avoid potential embarrassment all around. Almost forty years later, that’s the sort of clear message the markets are now looking for.

Share

I highlight several forecasts resulting from a mathematical model I use called the Qual VAR model. Those forecasts, which are published monthly here on Russell’s Helping Advisors, led me to write a dissenting viewpoint to those recently offered by some experts that a U.S. recession is inevitable.

I believe that employment data, in particular, will make it hard to distinguish in coming months between a stalling U.S. economic expansion and a U.S. economic expansion that is slowly rebuilding momentum from scratch. Based on my Qual VAR model, I believe there are actually signs – things like yield curve spreads between the three-month LIBOR¹ and three-month Treasury Bills, as well as between corporate bond yields rated Aaa and Baa – that actually show a clear lack of the kinds of economic stress that typically would be present prior to a recession.

Is a U.S. recession possible? Absolutely! If an economic shock – say a European banking crisis following a Greek default – occurs, that negativity could be transmitted to the U.S. economy with sufficient severity to cause a recession here. But I believe that investors should be – and are – more concerned about Japan-style economic stagnation right now than about a traditional recession.

You can read more about my views in detail on the Econbrowser blog.

Share

Individuals facing retirement are often met with a very challenging task. First, they must consider what income they need to support the lifestyle they want to live. This may be painful as they discover the lifestyle they dreamed of beyond their means, at least for the present. This may mean they have to continue to work and save longer to get closer to that lifestyle goal. For others the decision has more gray area.

For these folks, their lifestyle (and by extension income) goals may be obtainable if they are willing to increase the risk levels of their portfolios. While this can be a reasonable decision it should never be taken in isolation. The investor must consider their ability to tolerate increased fluctuations to their principal, and how they would react when markets make them nervous. If one is inclined to liquidate their portfolio for comforts sake, this is almost always a recipe for failure.

On the other hand, there are a few investors who find themselves in the enviable spot of having a sufficient asset base to fund their lifestyle needs with less risk. While these investors may seem ahead of the curve, they also must consider risk. For these folks, it may seem tempting to seek out the best possible return as their capital base provides some safety net. However, these investors should also consider their risk tolerances in the worst of times as a liquidation can impact them as well.

Whatever your current financial situation, have a conversation with your financial advisor today about your income goals in retirement. The sooner you develop your goals the greater your chances of reaching these goals. Understanding your situation and yourself can help you manage your risk better. Because after all, as universal as risk may be, success is personal!

Share

Share

And so, week to week – even day to day – markets are whip-sawed by any news tidbit that might point to darkening clouds or a clearing in the distance. This leaves investors who try to keep up with market news each day feeling dizzy.

On this week’s Market Week in Review video, Mark Eibel offers sound advice to investors while making some sense of the disparate headlines that have moved markets this week. Leave the daily headlines to someone else; watch Market Week in Review to get the only news recap you need. Mark Soupiset hosts.

Share

Despite some demographic parallels, there are many differences between the two countries and we believe that the U.S. will be much better able to adapt to an aging population amid the current financial crisis than Japan was in the late 1980s and early 1990s. If you’re interested in understanding the many lessons that the Japan test case gives us as investors today, I encourage you to visit the Insights & Research section of Russell.com to read the full paper: Japan Disease: Can It Happen Here?

In my previous post, I asserted that the U.S. has three primary advantages relative to the Japan of the early 90s in terms of avoiding economic stagnation. Today I want to give eight more reasons why I think the path the U.S. will follow is quite different from the difficult road Japan endured:

8 reasons the U.S. won’t follow the Japan path:

1. Real estate comprises a much lower share of total wealth in the U.S. than it did in Japan during the bubble years. Real-estate wealth has shown little bounce-back in Japan but with a rising population, the United States will likely work through the excess housing supply within about five years.
2. Japan was a much more export-dependent economy that faced an enormous adverse shift in the exchange rate from about 240 yen/dollar in the mid-1980s to about 80 in 1995. The U.S. dollar, in contrast, started to decline in 2002 and is currently at record-low levels on a trade-weighted basis against other major currencies.
3. The U.S. has a bond-based financial system, in contrast to Japan’s bank-based financial system. The latter led to the phenomenon in Japan of ‘Zombie’ banks that were unable to write down impaired assets and, thereby, unable to refresh their lending. In a bond-based financial system, previous issuance of flawed bonds does less to prevent new issuance of solid bonds. A case in point is the current vintage of mortgage-backed securities from Fannie Mae and Freddie Mac. Bond buyers recognize that today’s stringent mortgage standards are designed to ensure that the current vintage of mortgage-backed securities is very solid.
4. The U.S. acted very quickly to recapitalize the banking system through the TARP program during the early stages of the financial crisis in October 2008. This recapitalization restored much-needed confidence in the stability of the financial system, as seen in the decline in interbank lending rates. In Japan, in contrast, reticence about interbank lending continued through 1993.
5. As painful as it has been, the real estate foreclosure process has proceeded much more quickly in the United States than it did in Japan. This will likely get us to a clean slate sooner.
6. The Federal Reserve in the United States was much quicker than the Bank of Japan to undertake Quantitative Easing (QE). By QE, I mean that once the central bank has taken the short-term interest rate to zero, it can either inject the minimum amount of reserves into the banking system to maintain the zero rate, or it can inject more than minimum amount. When it does the latter, this is known as QE. The Bank of Japan first took the short-term interest rate down to zero in 1996, but did not conduct any QE until 2001. The U.S. Fed initiated QE within about three months after taking the short-term interest rate to zero in December 2008.
7. The “save-first” reflex in Japan is not shared by households in the United States. Our spendthrift ways actually are helpful in aiding accommodative monetary policy, especially Quantitative Easing, to prevent deflationary stagnation.
8. The U.S. enjoys a much higher rate of small business formation than Japan, which helps reallocate productive resources to new uses expeditiously.

Ultimately, our economic outlook for the U.S. is that improvement in business cycle conditions will be a long, arduous process and the projection from the Obama Administration is that the unemployment rate will remain above 6 percent through 2017. Although the current decade is poised to go down as a high-unemployment one, we believe America will fare much better than did Japan more than 20 years ago.

In the immortal words of Herb Stein, things that cannot go on forever don’t.

If you have any questions about this article, please contact your Russell representative or financial advisor.

Share

This has implications for investors of all sizes in terms of portfolio construction, asset allocation and risk models, but I believe understanding whether slow growth and debt issues will lead to a period of economic stagnation for the U.S., induced by our own demographics, can likely help investors make better long-term investment decisions.

I wrote about this recently in a paper in which my colleague and I looked at the lessons we can learn from the long economic stagnation that Japan went through – starting with a stock-market and real-estate bubble which burst in 1989. You can read the paper on the Insights & Research section of our website: Japan Disease: Can It Happen Here?

We found many similarities to the situation the U.S. is in today. Japan’s problems were exacerbated when its aging population – believing it would have a secure future through economic growth and high returns on savings (neither of which came to fruition) – took on debt to fund speculative real-estate investments. The result ended in tears when Japan’s asset-price and real estate bubbles burst. Sound familiar?

Despite the déjà vu, we concluded that the U.S., as an economy and a society, is much more flexible and adaptive than Japan on many dimensions, including:

1. Keeping our workforce young: No other developed country has the capacity to absorb immigrants of all education levels like the U.S., thereby providing a population of younger workers better than the native population could provide.
2. A growing population: The birth rate is much closer to replacement rate in the U.S. and when combined with immigration, this ensures a growing population in stark contrast to projected declines in Japan.
3. Shift to DC retirement plans: The transition from traditional defined benefit (DB) pensions to defined contribution (DC or 401(K)-type) retirement accounts makes it much easier for workers (and society) to adapt to changed economic circumstances by working more years to lift their retirement account balances up to a desired level.

All of this leads us to conclude that our bout with the “Japan disease” will likely prove to be a case of mononucleosis and not a deadly pneumonia. Tomorrow I’ll provide further proof, talking through eight additional advantages that the U.S. today has relative to the Japan of the early 1990s, and I’ll provide a look at our current economic outlook for the U.S.

Share

Share

Thursday’s sell-off: What matters most in times like these

Many people are asking me and Russell’s Strategist Team about our views on the significant market sell off yesterday and today. You may recall from last week’s update Doctor, Do Something! – Russell’s economic “check-up”, that the biggest factor that the market is dealing with is Europe and how the crises will eventually be resolved, one way or another.

Even though the “news” is saying that the last two days is about the U.S. economy, it seems fairly clear to me that the real issue continues to be Europe. On balance, the economic news that has come out this week has been mildly positive, jobless claims down, leading economic indicators improving and the IMF saying the global real GDP growth rate is likely to be 4%. So why the market move?

Even though the incremental economic data for this week is mildly positive what it points out is that the economy is weak and vulnerable. Did anyone really not know this before the Fed telling us that yesterday?

That is why I believe that this is really about Europe. The reality is that the global economy is fragile. The uncertainty of the Euro endgame creates the very realistic possibility that if it ends ugly, or if the uncertainty is prolonged or heightened indefinitely, the economy may be driven into recession because of a crisis in Europe or sentiment.

This is still not our expectation but because politicians are involved, it can’t be dismissed.

It’s important to remember that extreme volatility like this is going to continue until the underlying problems are solved. Day to day, the market is looking at every bit of news – from fundamental economic data to political posturing, from the significant to the trivial – and trying to make sense of it. And, frankly, we believe that often the market is over-reacting.

Tomorrow I’ll go into more detail regarding what we’ve seen this week in our weekly Market Week in Review video segment. It will be posted here by mid-afternoon Pacific Time, and I encourage you to tune in for that. In the meantime, remember that your long-term investment strategy is rooted in the expectation that in volatile times discipline, rather than emotion, drives the decisions we make. This is easier said than done in volatile times, that it is why it matters most in times like these.

A final reminder, if your investment horizon (at least for some of your assets) is at least five years, which if you own equities it should be, then we believe that stocks are cheap and by the end of that period now may look like a good buying opportunity.

To use a driving metaphor, keep both hands on the steering wheel, look to the horizon and keep moving forward.

Share

In the summer of 1980, more concerned with baseball than the weather, even I knew it was hot. This was the summer that the nation asked, “Who shot J.R.?” referring to Larry Hagman’s character in the hit TV show “Dallas”. But folks in Dallas wondered if we were returning to the Dust Bowl. That summer we experienced 69 days of more than 100 degrees with 42 of those being consecutive. In short, it was the kind of oppressive heat that makes most of the country wonder why we live in Texas.

So it was no surprise that a form of gallows humor set in this summer as we approached the record. Day after day we soared up into the 100s as people both cheered the impending new record and hoped for a reprieve. So it was bittersweet to dine al fresco in cool evening shade on the 41st day we only reached 98 degrees. We had the record so close and just as it seemed certain we were destined to break it, the conditions changed. This seems a metaphor for the markets of the summer of 2011.

With news of the debt ceiling gridlock, debt rating downgrades and a European debt dilemma, many investors began to seek the similarities to 2008. In fact, when speaking at client events I was asked if this was 2008 all over again so many times I began to start each presentation with this very comment (for the record, we don’t believe this to be another 2008 market). And just as the media started referencing 2008, many markets calmed down and started to climb off their bottoms and return to more normal values.

As challenging as markets and weather can be at times, the extreme conditions do tend to be short lived (at least in hind sight). If we can keep our calm and give our asset allocation time to work, we are often rewarded for our patience. After all, as hot as summers may get we will likely all complain of the cold by the time February rolls around.

Share

Share

Share

Share

Share

Backwardation – The Spot price is greater than the Futures price.

Contango – The Futues prices is greater than the Spot price.

Essentially, when the market is in Backwardation, the commodities buyer (or the “Consumer”) receives a discount for delaying his purchase. By contrast, in Contango, the commodities seller (or the “Producer”) gets a premium for holding on to the inventory. There are all sorts of theories out there as to why Backwardation and Contango exist at various times for various commodities. The most popular one is that Contango is the result of large inventories and expensive storage costs.

Regardless of the reason for Contango, there is a common belief that rolling commodity futures in the face of Contango is equivalent to buying high and selling low—or losing money. Fortunately, this is a myth.

The case of kryptonite, again

February 15
Recall that investor Clark has $100 to invest in kryptonite. The spot price of kryptonite on February 15 is $99. The price for the kryptonite 1-month futures contract is $100. Kryptonite is in Contango because the futures price is greater than the spot price.

March 14
Now let’s fast-forward to March 14, and the futures contract is close to expiration. At this time, the value of Clark’s futures contract is $107.25, and the value of his collateral is $100.05. The market value of spot kryptonite is $107.

Given these prices, Clark earned 7.25% from the kryptonite futures and 0.05% from the collateral, resulting in a total return of 7.30%. But wait…I thought Contango meant losing money?? Clark paid $100 for the futures contract even though the spot was only $99, doesn’t this mean he got a raw deal?

Well, not really. The return is not based on the spot price at the time of purchase, but the value of the futures price at the time of sale.

Debunking the myth Negative Roll ≠ Losing Money
Because the futures contract is worth 7.25% on March 14th and he also gets the collateral yield of .05%, Clark’s return was actually 7.30%.

When Clark purchased his kryptonite futures, the 1-month futures contract was “more expensive” than the spot contract, i.e. the market was in Contango. Yet, Clark made a positive return on his futures purchase.

This demonstrates that the relative prices of spot and futures are not directly relevant to the investor. The only relevant prices are those of the futures price purchase and the futures price sale. These two prices are what define the return for the investor.

Author’s privilege, again

Ok, I will admit that I set the numbers up so that Contango ≠ Losing. Again, I can do that because I’m the author. Certainly, investors may lose money when the market is in Contango…and they may lose money when the market is in Backwardation. However, don’t ever assume that a Contango means that you always lost money nor that Backwardation is an easy tailwind. Look at your returns and decide for yourself.

Share

Share

It’s very easy to imagine that eventually someone who owns CEFs will need to sell those shares when buyers are scarce. In fact, such a situation is pretty common – the owner will sell at a “discount” just to liquidate. It is also possible that the buyer has to pay a premium for a much desired CEF, but this is less common than the discount scenario.

So, how does one make money given this situation?

Capitalizing on CEFs involves purchasing discounted closed-end funds from these sellers and then waiting for the price to recover before selling them again. Just as the discount happens because someone needs to sell at an unpopular time, price may recover for a variety of reasons. Of course, these investments include the risk the value may never be realized by the market but buying discounted CEFs and selling them when they are closer to their true value is essentially the same as value investing – buying cheap and selling when value is realized.

Share

Ever since these two concepts were defined, investors have been comparing roll return to spot return. In particular, if the return of spot copper is greater than the return of futures copper, the futures investors may feel like he has “lost money”. But what if the return of the copper futures is positive, but the return of spot is positive and a little more, did he really lose money? Let’s consider the case of kryptonite.

The case of kryptonite
Let’s follow kryptonite investor Clark, with $100 to invest. The spot price of kryptonite on say, February 15 for example, is $99. The price for the kryptonite 1-month futures contract is $100. If Clark wants to take delivery on kryptonite, he would pay $99 for it, or by paying $100 he can just hold a futures contract.

Keep in mind kryptonite is very difficult to store (it must be kept in a lead vault), and it requires both security and insurance, which runs one dollar per month. So Clark opts to purchase the futures contract for $99 and put his $100 in cash to earn his collateral yield.

Now let’s fast-forward to, say, March 14, and the futures contract is close to expiration. At this time, the value of Clark’s futures contract is $107.25, and the value of his collateral is $100.05. The market value of spot kryptonite is $107.

Given these prices, Clark earned 7.25% from the kryptonite futures and 0.05% from the collateral, resulting in a total return of 7.30%. But if he had invested in spot kryptonite, wouldn’t he have earned $8 on $99 or 8.08%?

Well, not really. Remember that storage, security and insurance is one dollar per month. So $99 to buy kryptonite means he really would have spent $99 and only received $106 a month later. His actual return would have been 7.07%

Debunking the myth Negative Roll ≠ Losing Money
The futures contract earned 7.25%. The spot earned 8.08%. Those naysayers who like to compare spot and roll will say that the roll return was a negative 0.83%. Hello…Clark earned +7.25% from the futures contract and 7.30% when we include his cash collateral yield! How is this losing money? I’m just not getting this one, but it happens over and over again.

But here is the real clincher: if Clark bought physical kryptonite at the spot price, he would have paid storage, security and insurance. His actual return would have been 7.07%. This is still positive but not as much as the futures return.

Author’s privilege
Ok, I will admit that I set the example numbers up so that roll return is negative, but both spot and futures returns are positive. I can do that. I’m the author. Certainly, spot, roll, and futures returns can all be negative simultaneously. However, don’t assume that a “negative roll” means that you always lost money. Just look at your returns and decide for yourself.

Share

• Japan’s GDP numbers, negative, but not as bad as expected.
• Germany’s GDP numbers, positive, but not as good as expected.
• The lack of dramatic action from the Sarkozy and Merkel meeting.
• More negative market rumors regarding European banks.
• Negative U.S. numbers for manufacturing, housing and unemployment.

According to Eibel, the only weight on the positive side of the scale was an accommodating Fed policy, but it wasn’t enough this week. Watch now to see if Eibel thinks this all adds up to another recession or just a continuing slowdown.

As events continue to unfold about the global markets, Russell Investments’ experts will continue to share their insights with you.

Share

As events continue to unfold about the global markets, Russell Investments’ experts will continue to share their insights with you.

Equity markets drop sharply in Europe and U.S.
After a few days of relative calm, markets dropped sharply in Europe and the U.S. This reflected investors’ continuing concerns about the unfolding European debt crisis and the stability of the European banking system; negative reaction to U.S. economic reports on a drop in existing home sales; and the sharp decline in the Philadelphia Fed survey of U.S. manufacturing activity. The Russell 1000^® Index was down 4.6% and the S&P 500^® Index was off -4.5% for the day.

Today’s activity reflects the same themes that have played out in global markets over the last several weeks. The fiscal issues in Europe and the U.S. have been years in the making, and solutions will not be found overnight. In this period of uncertainty, as the situation continues to unfold, investors can expect more events that could prompt extreme market reactions – both positive and negative.

That said, the market clearly remains concerned about the sovereign debt issue in Europe and its flow on effects into the banking system. With a day to process the outcome of yesterday’s meeting between French President Nicolas Sarkozy and German Chancellor Angela Merkel, the market clearly was looking for more. In addition to the stock market sell-off, we saw a strong rally in U.S. Treasury bonds, and the U.S. dollar strengthened against the euro in a likely sign that we continue to see capital flowing out of Europe and into the relative safety of the U.S. – what downgrade? This flight of capital may be one of the most discouraging signs to core European leaders and may significantly contribute to their incentive to act in their own self interest and take the necessary steps to fundamentally address the issues facing their markets.

Still on our radar: European debt and banking system, global economic recovery
Investors definitely aren’t out of the woods yet – we believe markets may be volatile through the remainder of 2011. As markets evolve, we will continue to monitor events and provide you with insights for your portfolio.

Going forward
In less volatile times, the Russell blog is a good source of information about a wide variety of investment topics. Note that the Russell Market Week in Review video filmed every Friday can also help you stay informed about events impacting the global markets.

Share

As events continue to unfold about the global markets, Russell Investments’ experts will continue to share their insights with you.

Markets react mildly to meeting between Merkel and Sarkozy
The U.S. markets appeared relatively calm after today’s meeting between German Chancellor Angela Merkel and French President Nicolas Sarkozy. After much anticipation, the meeting between these key European leaders did not result in dramatic solutions to Europe’s debt crisis.

After the meeting, President Sarkozy said that one proposal that has emerged recently, euro bonds, “can be imagined one day, but at the end of the European integration process not at the beginning.”

However, the market’s negative reaction today appears muted (Russell 1000® Index -6.95, S&P 500® Index -11.73, Dow Jones Industrial Average -76.97) compared to last week’s volatile swings.

Still on our radar: European debt, global economic recovery
While dramatic daily market swings may have subsided for now, we are still closely monitoring the European debt crisis and the broader global economic recovery.

Investors aren’t out of the woods yet – we believe markets may be volatile through the remainder of 2011. Challenges of this magnitude aren’t solved overnight. The pace of economic recovery appears to be slow and unsteadily steady. As markets evolve, we will continue to monitor events and provide you with insights for your portfolio.

Going forward
When the markets are less volatile, the Russell blog is a good source of information about a wide variety of investment topics. Note that the Russell Market Week in Review video filmed every Friday can also help you stay informed about events impacting the global markets.

In closing, remember that with so much uncertainty present, investment discipline and diversification can serve investors well.

Share

In the early days of AI there seemed to be a type of competing arms race between software and hardware developers to develop greater and greater functionality and capacity. As processing power grew, so would the computing demands of the software it ran. In some circles this was referred to as “Bill and Andy’s Law” for Bill Gates of Microsoft and Andrew Grove of Intel. “Whatever Andy giveth, Bill taketh away” was the tongue in cheek saying.

This reminds me of the state of affairs of many clients today. They work with their accountants, attorneys, bankers, insurance agents and financial advisors with little or no coordination between all of them. As talented as these professionals can be, their value is greatly diminished when they don’t work together. Even the most elegant estate planning solution can be compromised when coordination and communication is lacking. How do we get coordination among these counselors?

Consider hiring a Wealth Manager! At Russell, we define wealth management as the process of managing time, talent and financial resources to accomplish goals. These goals can include retirement, education and estate planning as well as philanthropy. A wealth manager is the trusted advisor who coordinates your entire financial ecosystem. This professional communicates with the other professionals to make sure you are on track and accomplishing your goals.

Each of your advisors is likely working very hard to provide you with the best possible solutions to your needs. But when they work together with a central coordinator you are far more likely to achieve a more holistic solution to your needs. Talk to your advisor and make sure they maintain a central strategy for your success. After all, there is nothing artificial about accomplishing your goals!

Share

As events continue to unfold about the global markets, Russell Investments’ experts will continue to share their insights with you.

Russell lowers year-end 2011 S&P 500 target
In recognition of the weaker economic environment and increased uncertainty regarding fiscal policy and sovereign debt in the U.S. and Europe, Russell has lowered its year-end 2011 S&P 500® target from 1372 to 1300.

That being said, stock fundamentals are solid, and current corporate earnings and balance sheets are strong. We believe that the current equity market level – and certainly the lows of last week – is based on the market pricing in a heightened probability of the U.S. slipping into recession in the near future. If, as Russell expects, the economic data stabilize in the third quarter and modestly improve in the fourth quarter, we believe that the stock market will rally as the recession scenario fades in likelihood.

Policy headwinds
Notwithstanding Russell’s view that the U.S. economy will skirt a formal recession, the U.S. and Europe face significant policy issues. The market’s concern over the potential outcomes of these hard-to-resolve issues is currently – and will likely continue to be – a drag on stock market multiples (price relative to current earnings). It is primarily for this reason that Russell is lowering its end-of-year forecast.

Investors should note that stocks currently face an unusually wide range of year-end market outcomes. If recent market and consumer sentiment prove to be too much of a hurdle for the currently struggling economy to overcome, the chance of recession is not insignificant. If policy errors occur, then quite negative market results could be expected. On the other hand, if policy makers continue to make slow and painful progress on the issues of the day, and economic growth rates begin to improve, stock prices could rally considerably.

The big meeting
While we are on the subject of policy challenges, all eyes will be on Europe tomorrow and the outcome of the meeting between German Chancellor Angela Merkel and French President Nicolas Sarkozy during which they will discuss Europe’s ongoing debt crisis. The market is certainly hoping for an indication that Europe might be moving closer toward a resolution. Tomorrow will tell.

Going forward
Thank you for reading this series of Russell Market Pulse blog postings. They have provided an important forum for communicating Russell’s views on timely investment issues. We will continue to write Russell Market Pulse blogs as market circumstances warrant.

In the meantime, when the markets are less volatile, the Russell blog is a good source of information about a wide variety of investment topics. Note that the Russell Market Week in Review video filmed every Friday can also help you stay informed about events impacting the global markets.

In closing, remember that with so much uncertainty present, investment discipline and diversification can serve investors well.

Share

Share

Jobless claims number inconsistent with a recession

Two events appear to have driven Thursday’s numbers. The first was the release of U.S. jobless numbers, showing a four-month low in new claims. The market was clearly hungry for some good news. Even though this number was far from ideal, its position below the 400,000 mark appeared to be considered a positive. Based on equity performance, the market apparently deemed this number to be inconsistent with a recession – at least for today.

The silver lining of political will

The second event was the agreement by German Chancellor Angela Merkel and French President Nicolas Sarkozy to meet on Tuesday, August 16 to address Europe’s ongoing debt crisis.

It’s hard to find a silver lining in the current environment, but here is one – strong negative market movements have the ability to create political will. We saw this in October of 2008 when the market crash made it palatable for former U.S. Secretary of the Treasury Hank Paulson, Jr. to arguably nationalize the banking system. We seem to be seeing this now, as the markets perhaps are convincing Germany and France to begin to consider the potential costs of not more fully addressing the European debt situation.

The question remains – has the market bared enough teeth so that France and Germany will be willing to start writing checks, buying bad debt at an accelerated pace and getting Europe’s banks back on a sound financial footing? Wait and see.

Share

And today’s European country in the sovereign debt crisis spotlight is…France

Volatility has and will continue to be a constant companion in this market environment. We were reminded again of that fact today as we watched the Dow drop 520 points, its ninth-worse point loss on record, in a market sell-off that effectively erased the gains made on Tuesday.

Whereas early-week volatility was based on concerns about the U.S. economy and the mostly psychological impact of the S&P downgrade, Wednesday’s drop is the result of the feared contagion effect of the European sovereign debt crisis. The crisis has moved from country to country – hitting the banking system in Italy, Greece and Spain. It’s also spilling over into the relatively more stable French and German systems given fears about exposure to shaky European debt. Today it was France’s turn in the chute.

France was singled out given talk that it could potentially be the next in line (following the U.S.) for a downgrade of its AAA credit rating, and because of swirling rumors about individual banks and their solvency. The market zeroed in on the fact that France has a strong trade relationship with Italy, and French banks own a good amount of Italian debt. France’s stock market absorbed the impact of these concerns, causing it to close down five percent.

The market’s focus on France is indicative of the fact that investors are beginning to pile pressure on Europe. In investors’ eyes, no market or country is completely safe, and they are making that view known. At some point this pressure, we believe, will create enough incentive for core Europe to address the fundamental solvency problem and stabilize the banking system by making the politically unpopular decision to “write a check” to aid peripheral Europe. Until that is done, capital flight, particularly to the U.S., will continue to be a big risk for core Europe.

We expect core Europe to respond, but it might be a painful process to watch play out

Despite the angst induced by the U.S. debt ceiling debate, a deal was reached. I have the same expectations for Europe, and I do believe that the resolution we’ve all been waiting for will come, as Europe has already done what’s necessary to avoid outright government defaults, albeit the bare minimum. This will continue to be a very painful process to watch play out. In the end, core Europe will “write the check,” holders of peripheral European sovereign bonds will likely have to take a haircut, and peripheral European countries will have to live within their means, but it’s good to see that some of these countries have already made pretty significant strides in enacting austerity measures.

As for the U.S. banking system, the market has been pummeling financials, but Russell’s view is that the banking system is not in the same precarious situation that it was in 2008. The system is now better capitalized, much less levered and more transparent. We can actually see this reflected in the way that the market is differentiating between bank stocks and pricing accordingly.

Right now, this issue is in the hands of European political leaders, but we believe that they will do what is necessary.

U.S. economy, while fragile, is standing on a number of strong pillars

As for the U.S. economy, the recovery is at a fragile point, but the Federal Reserve has made a strong commitment to stimulating growth – and they will do more, if necessary. Stock fundamentals are strong, business spending is solid, commodity-based inflation has been reduced, the supply chain disruption in Japan is ending and consumers have more money in their pockets.

A bright spot worth calling attention to is the U.S. tech sector, which has held up reasonably well during the dramatic market sell-offs we’ve seen this week. Specifically, Apple Inc. has overtaken Exxon Mobil Corp. as the “world’s most valuable company,” passing Exxon for the first time in intraday trading on Aug. 9. This is one notable example of how many companies – particularly in the tech sector – are posting solid business results and holding strong balance sheets chock full of cash – definitely good news. We’ll take it.

Share

After two days – about what I expected

Well, we avoided Financial Armageddon on Tuesday. If you’ve followed our blog this week, you know that Monday’s market close in the U.S. – and globally, for that matter – was worse than I expected; Tuesday’s close was better than I anticipated; put them together and the market’s reaction is what I expected two trading days following Friday’s announcement of the S&P downgrade.

Yesterday I wrote about the tell-tale signs of a sentiment-driven market – high volatility and high volume – and today we saw the markets come roaring back. Volume was still high on Tuesday but the VIX¹ – which is a measure of implied market volatility – fell from an intraday high of around 47 to close at 35. The Russell 3000® Index gained more than 53 points, or nearly 5 percent, while the DOW improved nearly 4% and the S&P 500 climbed close to 5 percent on the day.

No Christmas, but still not bad

The negative sentiment of Monday was reversed on Tuesday, and the day’s only significant news was not exactly what the market had hoped for – the Fed’s decision to keep the federal funds rate at zero to 0.25% at least until mid-2013 – but it gave the market something positive to hold onto. Granted, the Fed also downgraded its assessment of the U.S. economy for the third time this year, saying that economic growth has been “considerably slower than…expected.”

Still, I can’t remember a time when the Fed was date-specific like this with an interest-rate announcement. The market did not get the Christmas present it wanted today in the form of Quantitative Easing Part III, but it did get a clear sign that not only does the Fed stand ready to be accommodative until there’s economic progress made, the Fed effectively said it will be accommodative unless the economy far exceeds its current expectations. I was not alone in being encouraged by the Fed’s announcement.

I encourage you to be cognizant of how good you felt at the closing bell on Tuesday and how badly you felt after Monday’s blood-letting. Because the market continues to struggle with the economy, volatility isn’t going away anytime soon. But that’s all the more reason for investors to not overreact to short-term market moves and commit to stay the course with their long-term investment strategies.

Share

Compared to investing in the stock of a corporation for example (equity investment), bond investing is – on the surface at least – a simple affair. A bond pays a fixed amount of money on known dates. So if you want to place a value on a bond, you need to make a judgment about just two things:

(a) what each of those future payments is worth in today’s money (i.e. the discount rate, also known as the yield curve), and
(b) how likely it is that the payments will actually be made (default risk).

It’s when it comes to (b) that credit rating matters. In order to reach a judgment about ability-to-pay, all sorts of data is needed: cash flows, balance sheet structures, covenants and so on. Most investors don’t want to go through the routine steps of data discovery and basic analysis over and over. Instead, they rely on the credit rating agencies, the two biggest of which are Standard & Poor’s (S&P) and Moody’s. These agencies do the analysis (and overlay as much judgment as is needed) and assign a rating to just about every major piece of debt there is.

Is it a good thing for so many to rely so heavily on the agencies? Obviously not, if it means that nobody is doing any thinking of their own (and when the ratings agencies went seriously off-track in their ratings of complex securities during the mortgage bubble, there were lots of really big losers.) But as one source of information among others, they can be very useful. Plus, when regulators are measuring whether insurance companies and the like are being sufficiently prudent in their investment portfolios, the ratings of the agencies give an objective third-party assessment.

The highest ratings from S&P are AAA, AA and A. AAA means that “the obligor’s capacity to meet its financial commitment on the obligation is extremely strong” while AA “differs from the highest-rated obligations only to a small degree. The obligor’s capacity to meet its financial commitment on the obligation is very strong”. There are, indeed, three gradations of AA (because most rating categories below AAA can be modified by the addition of a + or – sign to show relative standing within the category.) Meanwhile, nine rungs below AAA on S&P’s ladder (twenty-two rungs if we include the “+” and “-“ distinctions) lies “D”, reserved for obligations that are in default.

Note just how high the AAA bar is, and what a small step it is down to AA+. Which takes us to the agencies’ view of the U.S. government. S&P’s decision to move the Treasury’s debt down a rung from AAA to AA+ may well prove very disruptive in coming days and months because of what it says about the strength of our financial system as a whole. It surely cannot have helped that the government came so close to default because of political wrangling just a few days ago. While it is true that the payments that seem to have been at threat of not being made were social security checks, payments to contractors and the like – not the payments due on Treasury debt – that’s not really much of a defense. One lesson that this past week has taught us is that, as with so much in this life, will matters just as much as ability; that sometimes a threat lies not just in whether someone can make good on their promises, but in whether it will ever choose for some reason not to do so.

Share

The article pointed out that Manhattan offers more in the way of cultural and entertainment options making it more valuable (Houstonians might disagree) and thus more expensive. While Houston offered a lower cost of housing it also offered Houston summers making it less desirable (no one disagrees summers are hot in Houston). However, one can’t help but wonder if there isn’t more going on in the valuations than the article might suggest.

For instance, there is no denying that Manhattan offers an urban lifestyle that few cities can approach and fewer still match. Meanwhile, Houston offers a suburban lifestyle that can be very comfortable. Both are attractive to some people. Simply stated, maybe people live where they do because they want to live there. They have jobs, families and local connections that make their location a part of who they are.

It seems reasonable the article would select New York and Texas as the two states referenced. After all, both can be descriptive and even defining of a person. In other words, our location becomes who we are. This may be all well and good in housing but it can be very detrimental in financial planning. Deciding that we are a “stock guy” can make us susceptible to taking on risks (sometimes unwillingly) that far exceed our expected rewards or even our needs. Even more challenging is the risk averse person who clings to bonds because they might protect hard earned principal but don’t offer enough growth to help the person accomplish their goals. In both cases, we have defined our portfolios by who we believe we are (the equity or bond investor) without the rational critical thinking of what we will become (retired and needing income). It doesn’t have to be this way.

Talk to your trusted wealth manager about what you are trying to accomplish and work together to implement the best strategy for you. You may find that as different as two choices are – when combined they make a wonderful solutions. After all, that’s why I live in Dallas.

Share

Could the market be its own worst enemy?
No doubt about it, negative sentiment trumped solid fundamentals Monday in the market. As the Russell 2000® Index lost 63 points, or nearly nine percent of its value, and the Dow shed more than 630 points (approximately 5.5 percent), it was clear that general concerns about the economic growth rate only exacerbated the blow absorbed on Friday when S&P downgraded U.S. Treasury debt.

When high trading volumes combine with volatility spikes, it’s clear that sentiment is ruling the market, and today that’s exactly what we saw as 2.5 billion shares were traded on the New York Stock Exchange – an incredibly high volume – and the VIX, Wall Street’s key measure of volatility, topped 46. The good news is that despite the downgrade, it’s not particularly surprising that U.S. Treasuries are considered a relatively safe investment, which shows that investors are not subscribing to the notion that the U.S. is no longer credit worthy.

On the other hand, in sentiment-led markets like we saw Monday, it is possible for the market to effectively talk itself into a recession, and this fear is one of the largest threats to Russell’s current economic outlook, which calls for growth in the latter half of the year. To paraphrase President Franklin D. Roosevelt, “one of the things we have to fear is fear itself.”

Outlook is sound, but ride will be scary
Russell continues to expect equity markets to recover from current levels, which is based on strong fundamentals, and a view that the U.S. economy will grow 2.5 percent in the second half of the year. The balance sheets of operating companies remain extraordinarily strong, and profits haven’t just been good – they’ve been great, as evidenced by 18% growth in second quarter earnings in the S&P 500.

These companies have been able to accomplish all of this despite relatively low economic growth rates, and some of the headwinds that created the economic soft patch - namely the Japan supply chain disruption and higher commodity prices – are starting to lose steam. All this means the outlook continues to be solid, and the events of Aug. 8 have all the hallmarks of being a very intense growth-scare market sell-off and not an indicator of a double-dip recession.

From a consumer perspective, there are some opposing forces playing out. As a positive for consumer spending, consumers generally have more money in their pockets right now due to an increase in real income and a drop in commodities prices, but investment accounts have also taken a beating in the last week, so loss of wealth can be a negative factor. It remains to be seen which factor will determine consumer spending in the second half of 2011.

What does this mean for investors?
Russell actively communicates with financial advisors and institutional investors, and we’re therefore mindful that investors of all sizes sense that the hard fought recovery of their portfolios since 2008 makes confronting yet another potentially difficult period doubly unappealing.

While we cannot say what is the correct path for every client, our experience has been that patient investors tend to recover more reliably from market sell-offs than reactive ones who need to predict successful exit and re-entry points, a daunting assignment. The good news is that dire predictions that the markets would interpret the downgrade as equating to U.S. bonds’ loss of value has not materialized to date.

In the backdrop of such a collapse of confidence, it is easy for people to lose perspective that successful investing is a long term – indeed lifetime – project. But another bad day in the stock market, while predictable under the circumstances, adds another straw to investors’ already strained backs.

For now, remain focused on your long-term objectives and understand that what happened today is about sentiment and does not appear to be about equity fundamentals. While a sentiment-driven recession is a possibility, we continue to believe that growth in the second half is a more likely scenario.

Share

The evidence seems to point to defensive equities offering better bang for the buck (i.e. better returns per unit of risk.) This goes against some theories of how the stock market ought to work – classic models such as Bill Sharpe’s capital asset pricing model, for example. That shouldn’t shock us – no model (and especially no model of the stock market) is perfect. But it does lead to the question of whether some institutional investors would be better off adjusting their portfolios to take advantage of this effect.

A colleague, John Osborn, and I have summarized the case for defensive equities in a recent research piece called Defensive equity: Is the market mispricing risk? With investors more interested than ever in managing risk of all types, we expect to see the debate continue and a reassessment of portfolio structure for many.

Share

And now this: Can the market’s psyche handle the downgrade?

As markets open for Monday trading on August 8, 2011, investors’ eyes will alternate focus between global bond and equity markets to gauge the reaction to Friday’s announcement by S&P that U.S. Treasury debt is no longer among the safest investments in the world. The drop to an AA+ rating marks the first time in 70 years that the U.S. hasn’t held the triple-A rating among the major rating agencies.

But is this the harbinger of economic apocalypse? Is it the signal of the beginning of the end of America’s global economic leadership? We don’t think so.

Our view is that recent negative market volatility reflects a drop in confidence in response to a spate of negative headlines – not a global economic collapse. Confidence of all shapes and sizes was tested last week by a sensational buffet of dire reports asserting the possibility that a weakened global economic recovery could slide off the cliff.

As confidence declined, speculation barreled ahead: But our analysis of the facts leads us to believe that although the economy has been weakened, a “double-dip” recession remains unlikely. The astounding volume of intraday trading activity on August 4 and 5 was a perfect mirror of rattled investors’ collapsed confidence. Add Friday’s downgrade announcement to the mix, and it’s understandable that investors are wondering how much more the markets can handle.

Eyes fixed on fixed income

We’ve been watching reactions to the downgrade through the weekend, and we don’t think the bond market is looking to S&P to determine what U.S. Treasuries are worth. In fact, last week’s drop in Treasury yield – which reflected a flight to safety – gives us a good indication that there is no significant concern about America’s ability to service and repay its debt. Our current thinking is that the bond market reaction to S&P will likely be muted. 

The downgrade does raise technical concerns regarding capital requirements for banking, insurance, derivatives and money funds, but the Fed, other regulators and governments in Europe and Asia have strongly stated that the risk weighting for U.S. Treasuries in capital structures “remains unchanged.”

Although it’s impossible to be completely certain how yields will react (panicky investors could choose to park their money outside of risk assets) there is reason to believe, based on recent history, that Friday’s downgrade will not necessarily prolong the current weak patch in the U.S. economy. Russell still forecasts roughly 2.5% in U.S. GDP growth in the back half of this year.

What’s in the cards for equities?

The wildcard is the equity market, which has been dealing with blows to its psyche for months in the form of the eurozone sovereign debt crisis, lackluster economic data, the U.S. debt-ceiling issue and now the downgrade. As of this writing on Sunday, August 7, the announcement is two days old and many nations have come out in support of the value and safety of U.S. Treasuries.

We’ve also seen a measured response in the U.S. futures market. Both of these events are potentially good news. Russell is cautiously optimistic that we will not see an emotional reaction in the equity markets on Monday, and although we do not expect it to be a good day in the market, we’re also not expecting panic. The early futures activity in the Asia Pacific market indicates a negative open to the markets, but not full-out panic.

Certainly the S&P downgrade won’t do anything to help speed the economic recovery in the U.S., which has been weaker and slower than we would have hoped, and we also anticipate that traumas such as those experienced last week will be a regular “companion” of the recovery. However, a double-dip recession does not look probable unless a negative spiral of sentiment makes it a self-fulfilling inevitability.

If you have any questions about this article, please contact your Russell representative or financial advisor.

Share

U.S. jobs number – not great, but good enough

On August 5, the market clearly liked the fact that the private sector created 154,000 jobs in July—with the biggest increases coming from health care (31,000), retail (26,000) and manufacturing (24,000). While the jobs number wasn’t great, it was better than expected, making it good enough to temporarily ease investor nerves about another recession. The manufacturing number in particular could be indicative that the Japan supply chain disruption (caused by the 9.0 magnitude earthquake on March 11), is no longer a headwind. 

Clearly the market remains concerned about soft economic data and fears that the U.S. economy is on thin ice, but from a forecasting perspective, the jobs number does make Russell more confident in our position that we will see growth accelerate in the second half of 2011.

There are also a number of indicators signaling that consumers may be coming back into the marketplace following second quarter doldrums, which is good news because consumer spending represents more than 70 percent of the U.S. economy. People are finding jobs (albeit not at the rate we would like to see), the rate of income per person is rising, gas prices are coming down, and we are in the throes of the “back to school” season.

Those positives aside, this market environment is still going to be a grind for some time to come.

Turmoil in Europe causes market clamor for U.S. Treasuries

Europe continues to be an area of focus for the markets, particularly Italy and Spain, as concerns mount that peripheral Europe will plunge further into crisis. Investors are looking to the European Central Bank to intervene, and halfway through the trading day the European Central Bank announced its willingness to buy Italian bonds and, by extension, Spanish bonds. That announcement took the market from solidly negative territory (evidently based on a rumor that S&P would downgrade U.S. Treasury debt at the close) to close essentially unchanged on the day.

Ride it out

We are going to continue to see ups and downs, highs and lows in this market environment. Remember not to act purely based on fear or emotion. Tomorrow could look very different from today.

If you have any questions about this article, please contact your Russell representative or financial advisor.

Share

Chief Investment Strategist – Client Strategies Erik Ristuben wraps up these topics and more in a bow and delivers them for viewers in this week’s Market Week in Review video. Mark Soupiset hosts.

Share

Ups and downs in the U.S. economy
The market is undeniably concerned about the economy hitting “stall speed” and is expressing that concern by rallying to Treasuries. It’s ironic that investors started out the week worried about the potential value of U.S. Treasuries given their credit quality – which could have led to a fall in price – and now investors are concerned about them being too expensive, as the 10-year yield is dropping – and dropping fast.

On the bright side, corporate balance sheets are fortresses of cash right now, and profits are extraordinarily high. If we can eradicate the fear of policy errors affecting the market, companies can – and likely will – spend money. Commodity prices are falling, and gas prices are moving meaningfully away from $4 a gallon. If consumers have a little more money in their pockets to spend, that could be a good thing for the economy.

Overall, the market needs to see an end to deteriorating economic data and fewer transitory green shoots.

Europe running out of runway
Europe’s runway grows shorter by the day. The market is pricing with grave concern that the contagion effect of sovereign debt is moving into the banking system, and as a result stocks of many banks hit 52-week lows. As a monetary authority, the European Central Bank has limited ability to solve fiscal problems. At the end of the day this is a fiscal issue, and Core Europe is going to have to commit real money in order to stabilize and recapitalize the banking system.

Let the market be fickle, but keep a steady hand
The markets are going to continue to be volatile. That’s a fact. Keep an eye on the news, but resist the urge to act too quickly in altering any investment strategy. Market activity is unfolding much too quickly.

If you have any questions about this article, please contact your Russell representative or financial advisor.

Share

U.S. economy = still shaky
Although we averted a short-term crisis this week by raising the debt ceiling, our economy continues to be shaky given the “mixed bag” of economic news that continues to be reported week after week. The ADP National Employment Report issued on August 3 wasn’t wildly positive. Even though the private sector added 114,000 jobs, layoffs are increasing. Even so, we do see growth accelerating in the second half of the year, although we continue to watch market data weaknesses with a very keen eye.

Italy and Spain grab the market’s attention
With the U.S. debt ceiling issue now set aside, Italy and Spain – two key members of the eurozone – are now taking their turns in the limelight. Both have 10-year government bond yields well above 6%, which could signal the beginning of a bailout process, as was the case for Greece, Ireland and Portugal. As an early warning observation, we expect that we will see news along these lines possibly as soon as the end of the week. From a portfolio perspective, consider maintaining an underweight position in peripheral Europe in equities and bonds.

Keep pace with the news, but don’t let it dictate your pace
Economic news will continue to come at us rapidly, so it’s important to watch the market, but stay disciplined in your investing.

If you have any questions about this article, please contact your Russell representative or financial advisor.

Share

Roll with it, baby…
With stocks and bonds, you can hold them for a long time and not really do much. Futures are different. A challenge with futures is that they “expire”. An expired futures contract is a bit more troublesome than an expired driver’s license. If you hold a futures contract on, say, live cattle and it expires, then you can expect (a) to owe somebody a lot of money and (b) receive a large delivery of live cattle.

Since most investors are not interested in the live cattle (nor the invoice that will come with it), they prefer to sell an expiring futures contract just before it is due and replace it with a new one. Replacing expiring futures with new ones is called “rolling” futures. If you roll futures, you maintain exposure to the commodity without ever seeing it.

Out damn spot!
Commodities futures do provide exposure to commodities. Investors like to track the “spot price” of a commodity. Spot is the return of the price of a physical commodity (like a barrel of crude oil). But remember, we don’t want to own the crude oil – we just want to benefit when the price goes up. Nevertheless, investors are endless in their comparison of futures prices and futures returns to spot prices and spot returns. (In my next blog entry, we will explore some of the issues related to this comparison).

Reaching for yield
One of the insights of investing in futures is that you don’t actually pay for them unless they expire (remember that invoice we talked about before?). Instead, you “post margin” usually at 10-15%. In other words, if I buy $1,000,000 worth of aluminum futures, I have to post $100,000-$150,000 with the broker. To “collateralize” a commodities future, you will also put the other 85%-90% ($850,000-$900,000) in an account. Therefore you have collateralized your entire exposure to that aluminum with cash.

By collateralizing your commodities futures you may actually put yourself in a more stable financial position. First, you will have enough cash on hand to pay that big invoice if you accidentally forget to roll. Second, you could earn two sets of returns – both the return from the commodities futures and the yield from the investment in cash.

Let’s review:
Spot – the return associated with the spot price of a physical commodity.
Roll – the act of replacing expiring futures contracts with new one.
Yield – the return of the cash used to collateralize the commodities futures.

Share

A deal is done – but the debt crisis isn’t over
August 2 is a date that has been circled on our calendars for weeks. It was the highly discussed deadline when the U.S. government was due to run out of money if it didn’t raise the debt ceiling.

Congress approved a proposal – one item on the government’s to-do list is complete. But many other issues remain.

The credit rating of the U.S. is still pending
Several of the major credit ratings agencies have yet to finalize the U.S.’s rating, though Fitch confirmed the U.S.’ AAA rating on August 2. Moody’s was less than positive in their language, but indicated that the AAA rating will stand for now. S&P #150; the most recently vocal on the issue – has yet to announce their thoughts. Opinions differ as to how important the credit ratings really are, but there are no doubts they are big psychological indicators.

The euro debt crisis and broad economic news are still looming
Though Congress’ deal is complete, sentiment did not improve much. Other very significant developments are affecting markets: the euro debt crisis is far from under control, and the economic news over the last week has been way below expectations. I believe that issues in Europe will come again to a head soon – in particular, Spain and Italy continue to face serious obstacles and are of sufficient size to make the markets nervous.

Keep a holistic perspective and watchful eye for your portfolio
All of these issues make this a particularly fast-developing world. Keep a broad, holistic focus on your long-term portfolio – currency, interest rates, equities – all these markets merit especially close attention. Uncertainty is always part of investing. This situation is nothing to panic about, but it does demand active monitoring.

If you have any questions about this article, please contact your Russell representative or financial advisor.

Share

Surprisingly, according to a 2010 NOAA study that compares annual rainfall averages for Dallas Love Field and Seattle-Tacoma International the difference is observationally indistinguishable. NOAA says over the last 30 years Seattle has received 37.07 inches of rain while Dallas has received 37.05 inches. Clearly, this doesn’t make a lot of sense when we look out a window. So how do we explain such a difference? It’s all in the math of standard deviation and averaging.

We all know that Dallas gets a great deal of its rain in the form of storms that bring a deluge in a few hours or days while Seattle experiences a more steady rainfall throughout most of the year. This means that while the total amount is similar the experience is very different. Sounds a lot like investing over the last 20 years or so doesn’t it?

While many advertisements tout an investment’s performance of the last 1, 3, 5 or 10 year period, any financial advisor knows to look beyond the basic numbers and explore what the return pattern looks like. While any number of investments may have a superior average return, when we look deeper we find a return pattern with a volatility that is not tolerable. In other words, even if the return looks good you won’t get this return if you liquidate the investment in a period of duress. However, it isn’t always simple to stay invested.

If you get those difficult periods right before you retire you may be sorely tested. This is yet another reason why it is so important to understand the risks of your portfolio. A trusted wealth manager that matches your goals to the right asset allocation can help you reach those goals while minimizing the risks you take along the way. After all, just as you wouldn’t plan a vacation without checking the weather, you shouldn’t make an investment without understanding the risks.

Share

Share

When the Battle of the Aires (billionaire owners vs. millionaire players) was over, my first thought was, “Now I can start thinking about my fantasy football team.” My second thought was that now that the NFL lockout has been resolved, the nation’s focus can shift to a similar situation: the federal debt ceiling.

Like the NFL lockout, the talks and negotiations surrounding the federal debt limit have been crawling along with no apparent compromise in sight. But if debt-ceiling negotiations fail past the August 2 deadline, instead of no football season, the U.S. could default on their $14.29 trillion debt.

How likely is a default? What effect will defaulting have on the U.S. economy?

“The current view of Russell’s strategist team is that the chance of significant financial market upset from what we are calling a ‘political earthquake’ is between five and 10 percent,” said Mike Dueker, Chief Economist, Portfolio Strategies Group. “At this point, people are hoping for an eleventh-hour deal on the debt-ceiling, even if it is not a comprehensive, multi-year agreement on deficit reduction.”

“In the event of a Treasury default, investors are likely to treat the new era as an ‘illiquidity regime,’ in which Treasury securities lose some of their luster. The liquidity of the Treasury market has made it the jewel in the crown of debt markets,” said Dueker. “A perceived reduction in liquidity would raise borrowing costs in a long-run average sense, but in the short run, there is a risk that such a debt debacle could weaken economic growth and hold down asset returns. Again, it’s important to distinguish this type of Treasury default, in which repayment is delayed but certain, from a default in which repayment never takes place.”

“A directly disruptive facet of a temporary default would be a debt downgrade from the esteemed AAA status. A downgrade would affect risk-based capital requirements for banks and insurance companies,” explained Dueker. “It’s quite likely, however, that any scramble for remaining AAA-rated assets could be alleviated by either an edict that counts Treasury securities as a zero risk or regulatory forbearance. The Bernanke Fed certainly knows how to stem a financial crisis.”

Whether or not congress can come together with a Hail Mary touchdown pass is still up in the air. The good news? We’re just a few short weeks from the start of the NFL season.

Are you ready for some football?

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analyses and opinions set forth herein are intended to serve as general information only and should not be relied upon by any individual or entity as advice or recommendations specific to that individual or entity. Anyone using this material should consult with their own attorney, accountant, financial or tax adviser or consultants on whom they rely for investment advice specific to their own circumstances.

NFL is a registered trademark of the National Football League.

Share

What are Frontier Markets and how do they differ from Emerging Markets?
Often overlooked in the investment conversations is the opportunity posed by Frontier Markets. It can be argued that today’s “frontier markets” are tomorrow’s emerging economies, as just thirty years ago, emerging economies were similarly undercapitalized by financial markets. These are country markets which are characterized by low market capitalization, nascent economic fundamentals, and varying levels of liquidity. Political structures may be problematic and the country underdeveloped in terms of infrastructure, education, and sophistication of business practices. Nevertheless, the long term prognosis for economic growth is positive. Representing 21.6% of the world’s population, these countries account for roughly 6% of the nominal world’s gross domestic product and about 3% stock market capitalization.¹ Moreover, since frontier markets tend to be more localized than other equity markets, they therefore provide diversification benefits of lower correlations to other markets.² Diversification lowers risk but as with other equity investments equities, loss is still possible.

What are the implications of demographics on the growth of Frontier Markets? The surprising example of Africa
As depicted above, UN demographers expect African population growth to outpace other geographic regions through the remainder of this century. While the “emerging” economies of India and China continue to dominate in terms of overall population magnitude, their populations are maturing. India’s population is beginning to age at a similar rate to developed countries. In contrast, China’s population is markedly aging due to the “one child” policy.

Demographers cite the 15-34 age cohort as typically the most productive in a person’s life³ in terms of education, marriage, and household formation. With the expectation of this cohort dominating the African region for years to come, the potential for productive economic expansion, growth of the middle class, and consumption of consumer products is still growing. Today, the African region represents more than 900 million consumers.⁴ By 2100, Africa’s 15-34 age population will be similar to China’s at around 1 billion with over 2.5 billion people added. (see charts)

How to structure investment portfolios to take advantage of the Frontier Market opportunity?
Emerging market investors may want to consider dedicating a portion of their strategic allocation to frontier markets. While a long term perspective and high tolerance for the lack of liquidity and perceived riskiness are prerequisites to frontier market investing, compelling risk adjusted returns provide opportunities. Moreover, the lower integration of these markets into global markets provides attractive opportunities for active investment management. The frontier markets of today offer excellent long term potential for the patient investor who is willing to accept an elevated level of risk.

Share

Of course, the numbers don’t end there. We can analyze each situation down to the smallest detail. We can find a batter’s average with runners in scoring position or how they hit versus left hand pitching. We can even find out how well they hit with two strikes against lefties with runners on the corners after the fifth inning. In other words, baseball is a game made for the mathematically inclined. Not all folks share this love though.

My wife and daughter cannot contain their boredom for more than a few minutes. I understand to the uninformed (or unconcerned) that baseball can look very slow to develop and the nuances are not readily apparent. However, those with an appreciation are amazed at all the little games that go on inside each play. Factors like pitch selection, runner’s intentions and if the infield is playing up are all combined to make for exciting theater inside of a very slow-paced moment. The same can be said of asset allocation as well.

Many investors (even some professionals) view asset allocation as a sleepy area of finance. Certainly, compared to breathless traders shouting buy and sell orders it looks downright bucolic. However, an investor’s asset allocation will determine the majority of the returns they experience.*

With this in mind, I encourage you to have (or revisit) your asset allocation with your trusted advisor. They can help determine the right allocation for you and the goals you are striving to reach. Keeping asset allocation as a topic in these conversations will help you stay on plan to reach your goals. And reaching those goals is the best home run of them all!

Share

Share

What I mean is that the harder and longer I ride it only serves to highlight the otherworld level of fitness these athletes possess. Of course, fitness alone is not enough to win. They must have a great team and more importantly an understanding of the challenges they face and how they will respond in a given circumstance. Through years of training and preparation they learn how to respond to each challenge in order to maximize the results their hard efforts achieve.

Sadly, as investors we’re seldom in the position to determine how we’ll respond to market volatility before it happens. Most times we’re faced with a downturn and left to debate if we have enough “intestinal fortitude” to ride out the storm. Ultimately, its very difficult for us to experience the associated emotions and practice our response. But we do have at least one chance.

Nearly every financial advisor will ask you to complete a risk profile at some point. These profiles typically ask probing questions to create a risk score, which helps the advisor understand your level of risk aversion. Unfortunately, many times clients (and advisors) are guilty of speeding though these questions. Take the time to work through them with careful thought about how you would react to each circumstance. This will give you a more accurate picture of who you really are and help your advisor find the right solution for you.

A thorough self-examination on this profile can help you have a plan when times get tough. In other words, just like the cyclists on Alpe d’Huez you will know which threats require response and which do not. You will be in a position to win!

Share

Share

We are a fairly easy group to please, so everyone tends to defer to whoever does the planning. As the most seasoned road warrior in the family, this invariably falls on my shoulders. Now because I am a road warrior, I can – given clear guidelines – book a trip for four to virtually anywhere in the world using any mode of transportation in a matter of minutes. However, booking a family vacation comes with few guidelines and only a vague concept of success: fun.

With these loose rules I set about planning what I think will make everyone happy and try to do so on a budget that wont leave us in debt (if you follow currencies you know we wont be going to Europe this year). I make plans that partially satisfy all of us while pleasing completely none of us. Then, I present them for approval to my wife and upon passing that test, to my children. The process breaks down when we consider dates, summer camps, work and everything else. This repeats itself multiple times as we try to find one place that makes everyone least displeased in the magic window of time we have available. (We vacationed in Racine last summer).

All of this could be avoided. If we started with clear goals and guidelines before the planning began, we’d be far more likely to achieve success. This same lesson holds true for retirement and education planning. Deciding what’s important to you gives you a target. Knowing this target and creating a plan that will provide your best chance of success can make the journey a lot less stressful and far more fulfilling.

Defining and communicating your long term financial goals with your trusted financial advisor can help you avoid the common pitfalls and mistakes that so many people accidentally make. As my colleague Ben Jones points out, most people spend more time planning their vacations than they do their retirement. Avoid this trap by having a goal and a realistic plan. After all, if you don’t know where you are going don’t be surprised if you wake up one day not knowing how you got there!

Share

Share

We all know what stocks and bonds are, we’ve all watched the glorious ups and dramatic downs of our portfolios and it can all be pretty unsettling. The whole point of alternatives is that they behave differently and just might be able to ease some of that pain.

Stocks go up and down, but we like them because they usually go up more than they go down. Imagine that we also had some other option, let’s call it Not-Stock, which also goes up and down, but also goes up more than it goes down. But let’s also add a twist, these two investments go up and down at different times. Let me demonstrate examples:

Both of these investments could make your stomach turn. Now let’s see what happens when we put them together into a portfolio:

So check it out, the Stock + Non-Stock (SNS) Portfolio has some much calmer returns, but never goes negative. Here is more information to chew on:

In these examples, if you held Stock for five years, you’d have a 14% return (or $14 added to every $100 you invested). If you held Not-Stock for five years, you’d have a 7% return (or $7 added to every $100 you invested). However, if you kept exactly half of your money in Stock and the other half in Not-Stock for five years, you’d have an 19% return (or $19 added to every $100 you invested. Why? Because Not-Stock behaves differently from Stock and, therefore, diversifies to Stock.

Ok here is our answer: Alternative investments diversify stocks and bonds. Isn’t that cool??

Share

On day 2, the teams competing in the Tour race in the Team Time Trial. This discipline requires that each team race together as a whole to cover the course as fast as possible with each teammate (teams start the Tour with 9 riders) receiving the finishing time of the 5th teammate to cross the line. To the casual observer this looks like guys riding bikes in a line. But to a knowledgeable fan, the result is a spectacle seldom seen in sports of nine athletes racing inches apart from each other at speeds sometimes exceeding 40 miles per hour.

While motorsport fans readily understand “drafting”, the practice of using another’s slipstream to go faster, most folks will not realize how important this phenomenon is in cycling. In a paceline, where riders are lined up one after another, the lead rider is expending far more energy than those following. So while one team may have the strongest time trial specialist, this rider alone can’t consistently beat a team working closely together to go faster overall.

In fact, while teams share the workload among all nine riders the load isn’t distributed equally. The riders who excel in this discipline, usually the bigger stronger riders who will not be a factor when the tour reaches the mountain stages, will take longer “pulls” at the front of the paceline. Those riders who are marked for climbing stages or the general classification (the yellow jersey competition or Overall) may take shorter pulls so they are fresher later in the race. This is very similar to an asset allocated portfolio where different asset classes are combined for their unique characteristics. Just as some asset classes perform better in rising equity markets other do better in periods favoring fixed income markets.

By combining these asset classes in the appropriate weightings for you, your trusted advisor creates an asset allocation that melds your risk tolerances with your goals the result is a sort of team work of asset classes working for your benefit. They are combined in such a way to give you the best chance of success (reaching your goals) while managing the volatility you are forced to endure. In other words, your advisor has created a strategy that is designed to help you “win the race”.

Share

Share

If you are also a parent you have certainly looked at one major cost, the rising tuition for attending colleges. It seems colleges are more expensive than ever and growing at a rate far exceeding inflation. However, we all know that an education is only truly expensive when you don’t have it. So we are faced with two choices – ignore the liability and hope for the best or establish a comprehensive plan with our advisor that gives us a road map to accomplish this noble goal. I would suggest that even if your resources don’t allow you the luxury of the latter option, you should still take this course of action. But why?

If you understand the future liability, in this case the cost of an education, you can at the very least consider how you might achieve it. While making a lump sum payment into an account to fully fund four years of college isn’t an option for most, you may be able to make choices now that ease the burden later. Many of us have faced this challenge before in a different area in our adult lives.

Folks who started their careers at a company offering a retirement plan were more likely to see reminders that the money we saved in our 20s would be very powerful as we approached retirement later in our lives. Of course, many of us felt that there would be plenty of time to save for retirement when we were in our senior years like our forties (wasn’t being young and naïve great). With the benefit of hindsight, we can clearly see that a dollar saved in 1987 means more than a dollar in 2011 to our future. Here is a chance for a “do over”.

Talk to your trusted advisor and find out what the cost will likely be and what you can do to fund it. It sometimes isn’t fun to think about this kind of future cost, but it’s far better than blindly hoping for the best elsewhere. After all, as a great economist buddy once told me, “kids aren’t money-making projects”!

Share

Share

Because of this awareness and more advanced early warning systems, lives are saved every year. Of course, warning systems alone are not enough. You have to be prepared to take shelter when prudent. For this very reason, many homes in the tornado belt have a safe room, or in the case of my grandparent’s home, a “storm cellar”. This was basically a cement bunker dug into the ground that provided shelter should a tornado approach. It allowed us to continue about daily business knowing we had a safe haven if needed. Reflecting back to this makes me realize this isn’t a bad idea for our investment portfolio either.

We may hope that the global economy accelerates from its tepid pace and that we do not experience a market downturn. However, as always there are no guarantees and history teaches that sooner or later markets will challenge our staying power. But what if we were able to build a “storm cellar” for our investment portfolio and net worth? In fact, we may do this in one way by having a detailed conversation with our trusted financial advisor.

There are two key building blocks to this process:

First, make sure you have the right asset allocation that allows you to live with it in good times and bad. If you cannot tolerate the volatility associated with the pursuit of higher returns, then talk to your advisor about dialing back your risk. Second, and just as important, consider a reserve that can provide a period of living expenses should your portfolio struggle. This cash reserve may provide the comfort you need to give your financial plan time to work through good markets and bad.

Cellars don’t prevent the damage that storms bring, but they do allow you to ride it out knowing you are somewhat safe, at least in the short term. Have this conversation with your advisor when the skies are blue and you will sleep better the next time storm clouds appear. After all, even thunderstorms can sound soothing from the safety of shelter.

Share

Share

Economic models are easier to build if you assume that people make decisions for rational (i.e. predictable) reasons. The trouble is: real people make decisions for all sorts of odd reasons. You do not calculate the utility of oaties vs. sugar-frosted chocolate bombs when cruising the cereal aisle (something that the grocery store is fully aware of, strategically positioning the boxes to achieve their own objectives from your visit).

Hence the rise of behavioral finance. Behavioral finance is economics with a twist: it recognizes the irrational human component of our decisions, and explores how that affects the choices we make. You don’t need to invent a contorted “utility curve” to explain why people buy lottery tickets: they do it because humans have absolutely no intuitive grasp of probabilities. You shouldn’t be surprised that people will go to more effort avoid losing $20 than they will to try to gain the same amount: once something is ours we hate to lose it.

Initially looked down upon by the older generation of rational market economists, the importance of behavioral effects is now widely acknowledged in polite circles.

Share

You see, as I started following their progress through the playoffs I usually just checked scores and only occasionally watched the last few minutes. The one exception was a game they lost early on. Now I know it’s silly, but as a baseball guy I am naturally superstitious (I have never stepped on a baseline) and don’t want to cause another loss. While many of you will snicker at my train of thought, almost all of us are guilty of this “logic”. Of course, this isn’t logic at all but silly superstitions. Still, maybe we are hardwired as humans to look for patterns in everyday life.

We tend to consider our experiences and make lifelong decisions based on these very thin sliced observations that affect our entire outlook on life. Anyone who has ever let a sibling talk them into chewing foil or tasting horseradish knows they never have to repeat that experience again. But what if we take this “world view” a little too far?

Often investors mistake the performance of an investment for more than what it really may be. Bad decisions executed at good times may be profitable just as good decisions with poor timing may have poor results. My colleague Steve Wood points out further that investors only lose money on their good ideas (if you thought it was a bad idea you wouldn’t do it). Your best defense in most cases is simply to have a meaningful conversation with your trusted advisors to see what options work best for you.

Finally, don’t beat yourself up for being human. It’s our best quality and the one that makes us all part of this unique experience. When it comes to investing (and letting your big sister goad you into something) a rational mind is likely your best bet. However, should you find one of the Dallas based teams playing for a championship – well don’t expect me to be clean shaven!

Share

Share

In other words, if you feel uncertain about your job prospects you will likely curb your spending and try to save more money. On the other hand, if times are good you are more likely to purchase the type of items that require planning for most folks, like a new car or washing machine. The index tries to approximate numerically the way we “feel” about our prospects in the immediate term. For benchmarking purposes, 1985 = 100 with the most recent month (4/26/11) recording a reading of 65.4.

Most mathematically inclined folks like me appreciate the efforts to quantify something as ambiguous as how Americans “feel” about the economy. But the best piece of advice I ever got about interpreting feelings came from my rural Texan grandfather who was actually offering parenting advice (unsolicited I might add) – “Son, it takes a lot of “atta boys” to get over one “oh no”". He was telling me in his unique way that children need to be praised many times more often than they are reprimanded. While he never meant it this way, I can’t help but think of my grandfather’s advice when consumer confidence is reported.

After all, even if you view your situation as improving, it is still tempting to have a negative outlook given all the recent events in the world. So far this year has brought a series of events that do not inspire confidence. However, this doesn’t mean that our economy is not growing. In fact, while the economic recovery may be less robust than we hope, it is still growing. As my colleague, Steve Wood so eloquently stated, “this recovery is like running on a beach, slow and painful but still running”.

We may never have all the “atta boys” we would like to make us feel comfortable with our portfolios or the economy in general. However, we can realize that not all “oh no’s” are created equal and to stay focused on our investing goals. Because no matter the news, we as investors are still forced to invest and plan to meet our liabilities in the future. No matter if you are a pensioner or pension plan, staying focused on your goals gives you the best chance of reaching your ultimate goal.

*The Conference Board is a global, independent business membership and research association working in the public interest.

Share

Share

Share

Share

What should we be thinking about that we’re not?
If one takes a longer-term view (say, the last three years), the greatest driver of oil prices seems to have been the end of a global recession and the resumption of global economic growth. Pre-crisis, in July of 2008, oil peaked at about US$147 a barrel. During the global-financial-crisis oil prices cratered to below US$40 a barrel. Post-global-financial-crisis, but prior to the Libyan turmoil, oil had already risen to US$85 a barrel, due to the growth of the global economy. True, since the Mideast political turmoil began with Egypt, oil prices have risen from the high-US$80-range to over US$103 a barrel for WTI crude – but not from the $30s to over $103.

As you can see, these recent exogenous events are meaningful, but they are far from the only forces acting upon global oil markets.

Also, it surprises me that Saudi Arabia is not more in the news. Political demonstrations are happening there as well. The situation is far from the civil war of Libya, but the impact would be far, far greater. Remember, Libya provides about 2.5 percent of global oil. But Saudi Arabia is the second largest producer of oil, after Russia. Saudi Arabia is a game changer.

Let’s loop back around to the original question: How much of an impact will Libyan unrest and Japanese earthquakes likely have on 2011 economic predictions?
We don’t think either of these events is yet significant enough to greatly impact our late-2010 predictions for 2011. Here’s a little closing perspective: Oil prices are still well below the prior peak in 2008, when a barrel of West-Texas crude was fetching US$147. While current prices are higher, they’re not yet high enough to alter our projections. But we are staying alert, and stand ready to communicate with our clients, should our views change.

Again, we are looking for a significant and sustained price move in oil, not just a price spike that passes through. This is a serious matter that requires serious analysis: We should not confuse our choices about our summer vacation driving plans with our decisions for our long-term portfolio investments.

We are still comfortable with our previous outlook. We think that the odds support the story that it is still a grind-it-out recovery this year. And we still think the Russell 1000® Index will end the year around 760.

Share

What is likely to be the most important market consequence of these “exogenous” events in Japan and the Middle East?
In a word: Oil.

Japan and Libya represent demand and supply shocks, respectively, with potentially significant impact on global oil markets. Obviously, Libyan civil war has shocked supply estimates for available oil. On the other side of the ledger, to the extent that the Japanese earthquake slows down Japan’s manufacturing base and refinery output, there will be a shock to demand for oil, as well as other commodities.

And what have we seen in response to these shocks? In response to Middle Eastern unrest and potential supply shock, oil prices spiked. Immediately following the Japanese tragedy, oil prices plummeted.

World Oil Supply vs. Demand
Y/Y Pct. Chg

Source: Strategas, British Petroleum’s Statistical Review

Libya and Japan will continue to be, predominantly, oil stories. Oil is the game changer: And if we look at energy prices, the market is still in wait-and-see mode. Until we identify a high and sustained spike in oil – which we haven’t yet seen – we won’t be dramatically revising our forecasts.

How might Libya specifically impact the energy sector?
Unlike Japan, there is a meaningful long-term experience with Middle East unrest. Libya accounts for about 2.5percent of the global oil supply. And that supply just became uncertain. So directly, in the short term, you can expect oil prices to rise because of that small-but-significant supply tightening.

But it quickly gets more complicated than that. Libya pumps what is called Brent Crude, or sweet crude. It’s the diesel-friendly variety. This is the type of oil that Europe is most dependent on, because of, among other things, Europe’s high use of diesel fuel is required to power all those Volkswagen vans and Mercedes sedans. The U.S. market – which is unleaded gasoline-oriented, can also refine and use sour crude, or what we call WTI – West Texas Intermediate.

Crude Oil vs. Brent Crude
Source: FactSet, Russell Investments. As of March 18, 2011

So, instead of asking how the energy sector might be impacted, a better first question might be, what region will be most impacted? And the answer is Europe, based on their Brent-Crude dependency. Since the Mideast unrest began, Brent Crude has been trading at a premium of over US$10 versus WTI Crude. In other words, Europe is paying more for oil than the U.S. is.

Will the Japan quake also impact oil prices?
In a word: Yes. But perhaps not as much as initial reactions would lead us to believe. Let’s revisit the demand issue. Immediately after the Japan quake, oil prices plummeted.  The market seemed to think: “If the third-largest economy is going to be temporarily slowed due to this event, the demand for oil will go down. So prices should drop.” So we have these two forces – lower Japanese demand and lower Libyan supply – both influencing markets.

But global oil markets have quickly recovered to their “post-Libya, but pre-Japan” prices. This means that global oil markets are handicapping the Libyan supply shock more heavily than the Japanese demand shock.

Check back tomorrow for part three and Dr. Wood’s outlook on how these events will impact the economy in the coming year.  

Read the full April Professor Portfolio article >

Share

Dr. Wood, let’s start with the horrible tragedy in Japan. What will be the impact of the earthquake and resultant tsunami and nuclear situation have on global markets?
Obviously, my first thoughts go to the heart-breaking loss of human life that has occurred in Japan. But as I’m forced to put on my hat of professional detachment, I must try to assess the economic and market impacts of these events.

I hate to be flippant, but it’s impossible to model exogeneity. This is an academic way of saying that it’s difficult to forecast due to a market influence when that influence is outside the system. Empirical analysis works by looking at repeatable, recognizable events that occur over extended periods. So, it is not possible to be overly specific because there simply aren’t a large enough number of major natural disasters followed by nuclear disasters (in meaningful and large economies) to use as guides.

But what we can do is assess how those outside events impact our current forecasts and see if we need to make adjustments. Looking at what is known, our expectation has been, and continues to be, that the Japan disaster’s impact on global markets and the global economy is likely to be rather limited and not terribly long-lived. Have these events been structural game changers? We think not – at least not from what we’ve seen so far.

Now, the Japan tragedy will certainly have an impact on global economic growth, but perhaps not as large or lasting as some initially feared. Japan’s economy has been limping along, in a deflationary environment, for the better part of two decades. Japan never was going to be a driver of new global demand or growth in 2011 or 2012. For the driver of global growth in coming years, look toward China: the tightening of monetary policy by the Chinese government (and when it ends its tightening) will be far more impactful on the delta of global growth than the Japanese disasters.

So let’s look at those forecasts. At the end of 2010, at Russell we forecast that equity returns would be in the high single digits for 2011 and that overall U.S. economic growth would hover a bit over 3.0 percent for the year. We expect the 10- year US Treasury to end at about 4%. Our year-end target for the Russell 1000® Index was 760 and we spotted the S&P 500® at 1372. Keep in mind that forecasting is not an exact science, forecasts are inherently uncertain and can be incorrect.

Do we think the impact of earthquakes and political unrest will change those forecasts? Not meaningfully and not yet.

Check in tomorrow for part two of three, when Dr. Wood discusses the market consequences of the events in Japan and the Middle East.

Read the full April Professor Portfolio article >

Share

Share

At this point you may think I am talking about profiling – I am not. I have noticed that if my tie is knotted securely around my neck, I can wear it through the line with no questions asked. However, if my tie is just draped around my shoulders I am asked to take it off and send it through the x-ray machine. This seems odd that how a garment is worn could alter its “safe” status. Like any good analyst I decided to run an experiment and tested both ways multiple times at two different airports – and got the same result. While it’s no shock that appearances matter, it is interesting that something as benign as neckwear can receive different treatments. This is certainly also common in the investment management world.

We see examples of this everyday in TV network programming. For example, first an intelligent person may tout gold for everyone and supports their opinion with seemingly well thought-out arguments usually involving massive inflation just around the corner. Then after a series of commercials from sponsors who can help you execute your gold strategy, a new commentator, just as sharp as the last, may make a strong argument for equities or fixed income or international debt. This may create a very confusing situation for investors who pass by the channel. But who should a rational investor believe?

Depending on how one looks at the comments, they could follow the advice of either or neither. Both may have sound points and make logical arguments that have a degree of credibility. However, I submit that if we weigh both extremes we might find comfortable ground happily in the middle. It might be fair to say that including most or all asset classes in our portfolio gives us the best chance to reach our end goals. In other words, after all extremes are considered we usually find the best choice somewhere in the middle.

Be considerate of all your options when building your portfolio but remember that the investments are merely a means to an end. As an investor, you can ill-afford to let the appearance of sound investment advice derail your long term plan.

Just as the security line is a part of today’s travel process, screen your options and consider them carefully. And remember as Father’s day rolls around in June in the U.S., the fish tie is an option we can all avoid.

Share

Share

And speaking of jobs numbers and expectations, here’s a question for our blog readers: At this point in the economic recovery, are current jobs numbers better or worse than you expected?

Share

That’s the chain of logic that I think of every time I hear on the radio or read in the newspaper about some new study that shows a connection between two things; connections that the media take to mean cause-and-effect. Because while the flaw in the logic is obvious when it comes to the Ferrari (sorry, folks, the real cause-and-effect here is that if you’re rich you’re more likely to buy a Ferrari, not that if you own a Ferrari you’re more likely to become rich) – it’s not usually obvious which way the logic should flow.

In life – and in investment – cause-and-effect is usually much more subtle than simple correlation. For example, sometimes correlation exists without a direct causal link in either direction (something else may be causing both of the observed effects). It can be a mistake to jump too quickly from the observation of a correlation between two phenomena to a conclusion that either one must necessarily cause the other.

Avoiding this pitfall does not come naturally to us. Daniel Kahneman, a psychologist, has said that “the most satisfying Eureka experience of my career”¹ was when he was able to demonstrate that the tendency for trainee fighter pilots who executed a maneuver exceptionally well to follow up with a less successful attempt the next time through was not a result of the feedback they received from instructors but a simple case of reversion to the mean. Kahneman received a Nobel Prize® for his work in 2002 – so clear thinking in the presence of complex cause-and-effect may be a rare skill, but it’s a rewarding one.

For more on the misleading nature of correlation statistics, see: Correlations have fat tails, too.

Share

In this week’s Market Week in Review video, Russell’s Director, Client Investment Strategies Mark Eibel offers his insights into S&P asserting itself in the discussion before walking us through the progressively impressive earnings week in the U.S. and the reasons why some investors are finding their way back into the equity markets after a two-year hiatus. Mark Soupiset hosts this week’s episode.

Share

Agreed is that currency is quite different from equities or fixed income, in that it is necessarily a long-short position that creates an exposure of some kind as opposed to a “normal” long-asset investment. And we have seen that the debate over whether currency should be considered an asset class, or something else altogether, bears little fruit.

What has been fruitful is the debate over the nature of currency exposure. With stocks and bonds one can define a universe, observe historical behavior, and identify at least two moments – a mean and a standard deviation – by which one can begin building expectations for risk and investment performance. But how does one define these moments for currency?

There is no perfect answer to this. The Dollar Index Stock (DXY), which is a dollar denominated index of six equally-weighted major currency pairs, represents a large percentage of the overall currency volatility as may be experienced by a dollar based investor. But why equal weight them? And what of the other six billion, non-dollar based investors around the world?

Even more important, as Ian has taken great effort to point out, is that currency market risk in aggregate is poorly described if defined as a function of one’s long asset allocations. One popular proxy for currency risk, the difference between unhedged and hedged international equity index returns, gives us information about one particular FX portfolio. This unfortunately represents an investment policy driven only by the structure of an equity benchmark as opposed to the exposure characteristics of the currency market, qua currency. As such, that kind of proxy is not very helpful.

All systems need an axiom, a reference point to which all things that follow are anchored. The dollar, or the local currency of the investor, does well for traditional asset classes like stocks, bonds, and real estate. For describing the characteristics of pure currency market exposure, however, a more relevant and useful axiom is needed.

Being pragmatic souls here at Russell, sensitive to the needs and realities of our clients, we do not presume to offer the definitive measure ex cathedra to which all must adhere. Indeed, it seems that the perfect answer to this question remains to be found. We have however worked out both a rigorous framework for analysis of the question on a client by client basis, and provided some new insights for what we believe most institutional investors should take the time to consider currency exposure and make a conscious decision. Factor based models for defining currency risk allow for both its management and for its harvesting as a means of portfolio enhancement. To know more, one must read Ian’s paper here.

Share

Pension plan funded status can be determined by dividing the market value of assets available to pay pension benefits by the value of those benefits, also known as the liability. To calculate this liability, actuaries use an interest rate to discount future benefit payouts into today’s dollars. This rate is based on current yields of high quality corporate bonds.

If the yields on these bonds drop, the present value of the pension promises to employees increases. When this happens, plan sponsors can find themselves in a worse funded position at the end of a period than at the beginning, even if equity markets have performed well during that time. This is essentially what happened between April 2009 and September 2010.

Luckily for plan sponsors, discount rates have turned around since then. During the 4th quarter of 2010, the average funded status of pension plans that Russell monitors increased from 73.3% to 80.1%. While some of this improvement can be attributed to plan sponsor contributions (most underfunded pension plans are required to make quarterly contributions), much of this improvement is due to discount rates raising 40-50* basis points during the quarter.

Since the end of 2010, discount rates have risen by another 20 basis points or so*, while equity assets have continued to outperform historical averages. With equities performing well and liability values dropping, Q1 2011 was another solid quarter for pension plan sponsors.

Share

Share

Why? Let’s start with why global investors allocate to developed sovereign debt in the first instance.

Investment portfolios are constructed to meet clients’ objectives. The cornerstone of portfolio construction is to allocate X% to Risk-free assets and 1-X% to risky assets. Size of X depends on clients’ investment objectives for risk and return. The key point here is that allocations to sovereign debt are not made for some wider social purpose but to meet clients’ investment objectives. Sovereigns at their peril can assume that “this storm will blow over” and debt will simply be refinanced/rolled over for the next generation to pay for, but global investors are re-evaluating what “Risk-free” really means for their clients. Rapidly.

Previously, all developed sovereigns have benefitted by being cozily included in the “Risk-free” camp. Post the global financial crisis, when U.S. mortgage borrower pain was uploaded into developed sovereign pain, sovereign bond investors have increasingly sharpened their analytical pencils in the quest to determine what is, and is not “Risk-free”.

First degree of separation identified Greece as the sickest patient. Investors then became more analytical and neatly created the PIGS acronym (Portugal, Ireland, Greece and Spain) to assertively state these sovereigns were not necessarily “Risk-free”. The analysis and questioning will continue if more sovereign blood is spilt on the streets, exacerbated by Portugal currently opening its wounds in public. This will lead to wider metrics being analysed for separation.

What metrics could they be? Well, based on the tried and tested lending principle used to assess risky borrowers, that you should only lend to someone who is likely to pay you back, it’s reasonable to begin avoiding individuals, companies and sovereigns that year after year have spent more than they’ve earned and their level of debt is significantly higher than the rest of the candidate borrowers seeking your money. More specifically this could isolate borrowers whose budget deficits to GDP have consistently been negative for 20+ years in a row, and their debt to GDP levels are very high, say using >80% as an uncomfortable threshold. Four countries fall into this neat equation.

Two of those four (Greece and Portugal) have already been attacked by bond investors. The other two inmates (France and Italy) to that isolated cell, could rightly point to several mitigating factors to their credit risks such as larger diversified economies and less reliance on external funding. However, if bond investors dwell further that Italy and France also have the highest stock of debt in the world, after Japan and USA, at the margin, it could lead to such investors cautiously reexamining their “Risk-free” status, leading to lower demand for such debt and ultimately higher borrowing costs.

The most material issue that could come out of this sovereign debt crisis may not be posed in the short term of which country is under most pressure to repay its upcoming debt due, which ultimately will probably be resolved by ECB support, but rather it could be which countries may not be classified as “Risk-free” anymore. This wouldn’t hit any sensational headlines demanding emergency ECB support, but quietly and gradually, bond investors globally, could change their investment policies to more accurately define what “Risk-free” really means for their clients. That’s why Italy and France want Portugal to resolve its debt crisis.

Share

When Wall Street Journal reporter Katie Martin wrote those words about FX a few weeks ago http://blogs.wsj.com/source/2011/02/22/spot-the-villain-in-currencies-grubby-secret/, she turned me into a blogger. She was talking about the fact that “not all pension funds are treated equally” in terms of what they pay for currency trading in their international portfolios. She also noted that Russell Investments—along with other consultants—have been talking about the issue for years.

And I decided to take up my keyboard to blog about FX, since the financial press has been kind enough to place the topic front and center. In this fifth and final post, I’m going to talk about FX in the context of the development of the investment industry over the last 40 years. Specifically, I’m referring to the trend favoring transparency, competition, and lower fees for investors.

It all started happening in the mid-70s with the passage of ERISA in 1974 and the deregulation of trading commissions in 1975. Fast forward to the 2006 Pension Protection Act, which prompts employers to pay much closer attention to provider fees, including arrangements where multiple services are bundled into the investment fee. Bundling almost always involves shifting costs, inevitably benefiting some consumers at the expense of others. Today, this principle of unbundling is approaching its logical limit as regulators are scrutinizing banks that offer free checking!

In this environment, it’s surprising that the inefficiencies in FX have been so widely overlooked. When Russell first began offering to act as agent for pension funds’ FX operations in 2003, we were thinking mostly in terms of lowering transaction costs. However, as the business matured, we realized our value proposition is closely aligned with our clients’ fiduciary duty:

1. By reducing transaction costs we help improve fund performance, to the benefit of all the shareholders.
2. Our detailed reporting enables plan sponsors to accurately explain to their boards that the fund is fulfilling its fiduciary duty to obtain best execution.
3. Our seamless process minimizes the need for pension funds and portfolio managers to develop FX expertise internally, allowing them to focus on their core duties to the fund.

I think it’s fair to say that Russell’s approach has been consistent with the long-term trend toward open, competitive pricing. Thanks to the recent “furor,” best practices described in my series of blog posts in FX should become standard. This can only be a positive development.

Share

Share

At Russell, we’ve developed a process that is seamless for the managers in our funds and for our other clients’ investment programs:

1. Portfolio managers communicate their trades to us electronically.
2. We look for the best execution available from all of the OTC counterparties in our network. Today, there are various trading platforms that help facilitate the search for the best price.
3. Once we’ve seen all the data, we feel confident we’re executing our trades at the wholesale market price. We book the trades and send the details back to the money managers, using file formats that import directly into whatever system they happen to be using. We also use an electronic messaging system known as SWIFT to communicate the information to the custodian.
4. Finally, we settle the trades in a risk-controlled fashion using a settlement mechanism that specializes in FX. It’s called CLS, short for Continuous Linked Settlement.

Russell’s process is one of the most efficient in the industry. Our trading costs average out at less than one basis point. Our ability to minimize FX transaction costs for our clients is a function of our ability to minimize redundant trades, the pricing leverage that comes from significant annual trading volumes and the dogged pursuit of the best price. The magic’s all in the market; we just try to keep our eyes open and always ask the right questions on behalf of our clients.

In my final post on this topic, I’ll take another look at the headlines and try to explain the furor over FX in the context of the prevailing trends in our industry. Talk to you next week.

Share

It’s an eye-opening experience when you do the math to see how much a large pension fund might be losing over time. For example, suppose you’re a trustee of a fund that has $2 billion invested in international equities. If you or your portfolio managers don’t bother to manage the FX component of each transaction, your fund would likely be paying the retail price of approximately $2 million per year. However, if you had an agent acting on your behalf for FX trading, you are more likely to get the wholesale price, which could be as low as $200,000.

Could your fund’s beneficiaries benefit from an extra $1.8 million per year? Absolutely. And it’s not just about the money; there are issues of fiduciary responsibility involved as well.

As a plan fiduciary, it is your duty to pay attention to transaction costs. This includes securing best execution of trades in all your portfolios. Today, there are viable alternatives to the monopoly providers, which will allow you to manage your FX transactions cost effectively. Not only are you more likely to receive better pricing, but you should also benefit from full transparency on every trade, including time stamps and exact details about the spreads. Regular reports make it easy to document that you are indeed managing FX trading in the best interests of participants.

How do these specialist firms manage to cut the cost of FX trading so dramatically? In my next post, I’ll describe the best practices that we have identified and incorporated in our business.

Share

Share

As I explained in the first post in this series, the current interest arises from the fact that some of the world’s largest pension funds are suing their FX providers. But the underlying issue has existed for as long as investors have bought and sold foreign securities. My group was founded in 2003 precisely to help Russell clients—and any investor who cares about net results—reduce the cost of trading in their international portfolios.

During the post-dotcom hangover, we were looking for ways to add value in the Russell funds. During our research, we identified that some investment managers had little resources on staff to manage the FX component of their stock trades. Without really giving the matter any thought, they were outsourcing that part of the trading process. But currencies trade OTC, rather than on a formal exchange. So the institutions handling FX were actually principals trading on their own behalf. Since they had exclusive access to the information about the trading spreads, they were in effect monopoly providers with the ability to compensate themselves as they pleased.

It was a challenge trying to ferret out the actual cost of FX trading, as managers weren’t keeping records of time stamps or the corresponding spreads for each trade. Through painstaking reconstructions, we determined that FX was costing some foreign equity managers as much as 40 basis points of performance. On the other end of the spectrum, we also found managers who were able to limit FX costs to less than a single basis point.

In the next couple of posts, I’ll talk about the consequences of ignoring FX costs, as well as the best practices for investors who like the idea of keeping more of their own money.

Share

The fact is, every time you or your manager buys or sells a foreign security, a currency transaction also takes place. There’s nothing glamorous here. It’s not risky or speculative. It’s just a routine business necessity. But it’s important to understand that this makes you a de facto foreign currency trader, whether you realize it or not.

The current issue arose when some of America’s largest pension funds realized that they were doing quite a bit of FX trading (that’s industry lingo for “foreign exchange”) in their international portfolios. It occurred to them that their provider may have not been disclosing its fees for this service, with the suggestion that perhaps they were being overcharged to the tune of several million dollars per year. This suggestion was in the form of a lawsuit. Other pension funds noticed and decided it would be prudent for them to follow suit (excuse the pun) and also initiate a legal proceeding against their providers.

That in a nutshell is the current fracas over currency. And I’m blogging about it because I am positively fanatical when it comes to transparency in FX trading. To be candid: I work as the global head of foreign exchange at Russell. Since 2003 we’ve been tenacious about educating institutional investors on the true costs of FX trading in their international portfolios. That’s why I think we’ve got a great perspective and a lot to say about the current situation and how it affects you. Not the legal battles—we think it’s too bad it had to come to that—but the investment implications of FX trading.

In my next post, I’ll explain the why and how of Russell’s research into the true cost of currency trading. And in the weeks to come I’ll walk you through the math to show how the dollars can really add up, and describe the process we use to make sure our clients’ money stays where it belongs—in their own pockets. Finally, I plan to share a few words about how the “furor over FX” fits into the big picture for our industry.

Share

Share

Of course, the well documented images of current-day Somali pirates who attack, rob and even kill innocent boaters are top of mind, but I am thinking of a different kind of pirate. In fact, think of your carefully designed investment plan, which you may have created with your financial advisor to assist you in reaching your ultimate investment goals. When you crafted this plan it was most likely in a period of relative calm and long-term risk/return profiles were considered. You probably assessed the risks of different asset classes and thought about how they might work together to enhance your returns and manage risk. And then the pirates attacked.

They came as subtle ideas that seem logical at ‘cocktail party’ level analysis. After all, with the Fed engaged in QE2, inflation must be coming any second. And we fear inflation because our parents told us it was bad. What do we do? We get some gold. Like Calico Jack of yore, we chase the glitter. Does it help us? Are we better off? Did we make a good decision?

I would suggest not. In fact, I would suggest that these great ideas may have hurt us. But this is counter intuitive. After all, any investment opportunity generally has to be a good idea to ever be funded. If we thought it was a bad idea we would avoid it. But maybe the choices we make on ‘good advice’ that don’t exactly fit into our investment plan, might be the temptation we need to avoid.

We will always love pirates! Their clothes. Their mystery. In a word, they are cool. But cool doesn’t always make a good investment strategy. Before you jump aboard Long John Silver’s ship, talk to your advisor. He or she might have an idea for a safer passage that will ultimately make you happier.

Share

One of the things many people know us for is our manager research. And through our due diligence process we ultimately hire about 200 managers for assignment of the more than 8,000 manager products we research each year. If you like the frenetic activity of the NCAA tournament’s early brackets, when it seems games are always being played, you have to appreciate the volume of research. On any given work day, our analysts are conducting numerous manager meetings around the world. That’s a lot of action for the interested analyst to enjoy.

However, for any of the managers being considered, these “games” may be rather painful. The stakes are sometimes high, should they be selected for an assignment. First, Russell is known in the investment world as an intelligent and patient investor. Our understanding of a manager’s process allows us this capability. Furthermore, with an assignment often comes a significant amount of assets to manage. One might think of this process as an invitation to the Tournament. Some managers are very familiar with this process while others may be new to the role.

Finding these smaller managers can be very exciting for an analyst. While the larger, better known shops often do outstanding work, it is the smaller manager that can bring a fresh perspective to security selection. In fact, while our size allows our investors access to large managers, it is our scale that lets our analysts research these smaller, unheralded managers. After passing a full analysis, some of these smaller managers can make it to a Russell assignment over some of the more established firms.

We believe manager research makes us unique, and we take great pride in our work. While this process doesn’t offer the breathless excitement of a last-minute basketball three-point buzzer beater, it excites all of us at Russell. But then again, as a colleague once said, “we are a league of dorks.”

Share

Share

In our paper on the Middle East, we explain that the frontier Middle East region has outpaced the overall Russell Frontier Index (over the course of our sample investment period of June 2007-September 2010). And while the Middle East is well known for the abundant oil reserves and petroleum production, when it comes to opportunities for outside investors, financial services is the largest investable sector.

In recent years, the political instability and conflict in the region have often overshadowed the relative prosperity of the emerging economy of the United Arab Emirates, as well as the growing presence of frontier markets. Even so, the efforts many countries in this region have undertaken to open their markets and diversify their economies are presenting new opportunities for international investors.

Learn more. Read the entire paper: The Frontier Markets of the Middle East

Share

And the short version of how 2010 went is that both sides of the pension balance sheet grew significantly. Investment returns were healthy (helping to grow the assets from $578 billion to $619 billion), but falling interest rates meant liability growth was just as fast (the club’s pension liabilities went up from $700 billion to $740 billion). These 16 corporations made a combined $21 billion in contributions to their worldwide plans in 2010 – a sum comfortably in excess of the new benefits that accrued over the year – without which the $121 billion shortfall at the end of the year would have been bigger still.

There are three main ways in which that shortfall might be closed: interest rates could rise (which would reduce the value of the liabilities) – a possibility but not a certainty. Or asset returns could continue to be strong – again, possible but impossible to count on. Failing either of those, it’ll be down to the corporations to inject cash into the plans to bring them back up to full funding. Under the Pension Protection Act of 2006, the timeline for making these catch-up contributions is shorter than it was: in very rough terms, corporations now have 7 years to make up deficits in their U.S. plans. (Rules vary in other countries.)

So pensions remain a big deal for the $20 billion club and for the hundreds of other corporations who sponsor defined benefit pension plans. More details of how the club fared in 2010 can be found here.

Share

Share

The majority of the nations within the frontier Europe region are not as resource-rich as others that have recently entered the global markets. But they have more developed infrastructures, more stable governments and, historically, greater access to trade.

Learn how over-weighted the region is in large cap securities—just ten securities by market cap constitute more than 50% of the region. And find out which sectors within the Frontier Index are dominated by frontier Europe.

Learn more. Read the entire paper: The Frontier Markets of Europe

Share

Often family fortunes and investment decisions are made by one key decision maker, perhaps a husband or wife, with the implicit support of the other spouse. Furthermore, the children are seldom involved in the process for multiple reasons, both rational and emotional based. In fact, this is typically the rule and not the exception. On the flip side, most institutions are advised by a board of directors that will actively seek diversity in the decision making, such as members with differing ages, to provide a more rounded view. Finally, larger boards will have an investment committee that vets ideas and makes recommendations to the larger board of directors. In almost all cases there are multiple decision makers in the process.

Institutions also differ in that often they enter the market for investment advice with a clear set of parameters for what outcome they are seeking. It’s only after multiple respondents have been reviewed in a formal review process, often several rounds long, do they make a decision on who to hire. The key difference with individuals is that these decisions are often “event driven” by a retirement or other life change. At this point most individuals may ask around for a referral or two from a friend and hire the first person they meet. While by no means a recipe for disaster, this process might be better if taken a more institutional approach.

Finally, institutional investors—again made up of individuals—have one large advantage in their favor. While these investors may be just as susceptible to the “noise” of the media, it’s usually difficult for them to act on this “information” rapidly due to the required board approval. In other words, even if they read about “doom and gloom” or the “next big thing” in this morning’s headlines, they are unlikely to be able to act until vetting through the board.

In conclusion, it’s unlikely that the average family can bring the same amount of bureaucracy to their investment process as a large institution. However, they could be well served by involving trusted advisors and family members in the process and have an idea of what they want to accomplish with their wealth. Finally, putting some time between the origination of the next “great idea” and the implementation can be the most valuable piece of advice an investor can receive. Removing this burden from the shoulders of one decision maker can be a game changer. After all, as my good friend and colleague Dr. Steven Wood says, “you may lose money on yesterday’s good ideas”.

Share

Share

Over the last two or three years, I have found that this exercise of testing my physical endurance and thinking about the investment future on icily cold January days was more about a re-ordering of macro themes than an inclusion of new ones. As I have travelled the ski lift, my mind has surveyed the possibilities. As opposed to four or five years ago, we are now increasingly living in a world of polarities. We have inflation in the developing world and possible deflation in the developed world. We live today with the implications of developing countries having better fiscal balances than the developed ones and with multinationals emerging into a new age whereby their credit spreads may end up trading through or having a lower interest rate than government treasuries. This certainly has happened in the emerging markets from time to time but never really on a wholesale level in the G10. We also live with the constraints of economic theory and language—something I am increasingly pondering as central bankers emerge from the mists and become central players on the global financial stage. Finally, geopolitical risk has re-emerged, as seen in Tunisia and Egypt.

For Americans in particular, we are entering an age where we will have to think in multi-country and multi- currency terms. For two centuries and certainly since World War I we have never contemplated this. We have considered the “greenback” to be good as gold. Going forward we will have to consider whether we want to think about “flight capital” when we have historically been the place to which capital flew. Literally, do we have to hold Swiss Francs, South African rand, or even gold bullion in our liquidity pools to ensure the benefits, spending policy or light bills are paid? This seems really hard to consider given the roaring domestic equity markets and current “hot spots” in Tunisia and Egypt. Finally, the age of true “long only” and domestic versus international investing is likely over. Broad alternatives buckets and emerging markets will be integral parts of our core mandates. We will need to understand countries as well as asset classes.

With this in mind, here is how I think major themes might compare from 2010 to 2011.

• Currency has moved up to the number one slot for 2011. The uncertainties of individual central bank policy will make this “upfront and personal” in 2011 as opposed to just barely on the radar screen in 2009. American institutional investors have gotten this wrong for 20 years. This is the year where you either get it or it begins to get you. Capital controls, like those in Brazil and Thailand, will also be front-page news periodically and will begin to determine the next decade of returns. The definition of the “monetary trilemma” will be understood by all.
• Sovereign risk or country re-ranking moves down a notch. In a way, I could have combined this with currency, although the issues are slightly different. This painful process of understanding the chasm between high grade or functioning developing and developed countries, solvent and insolvent economies will continue to evolve. As has been said, the “north moves south and the west moves east.” While we don’t know the outcome, we certainly learned over the course of the last two years about the drivers of this risk. This re-ordering of country importance is profound and long-lived. It changes everything we consider at the policy level.
• Company re-rating or multinationals become sovereign risk. This is a mouthful. In early 2009, this little understood trend took the obvious form of impressive and historic corporate spreads over Treasuries, which then rallied late in the year. It was number one on my list for 2009. In 2010, increased stock prices for global companies put it as number two. Again, the market movements were overt. But In 2011, I would argue market movements may be misinterpreted too narrowly by U.S. investors and not broadly enough by global investors. This phenomenon is robust and likely to have decade-long legs. As an example, multinationals like Microsoft took the opportunity to issue 30-year paper at record low interest rates. With cash on the balance sheet and emerging market exposure, they are at a distinct and long-lived advantage to their more leveraged neighbors and competitors. One could posit that this might only imply significant differences in valuations. But if one really thinks about this, the more profound trend is that multinationals whose business operations and debt issuance capacities are truly diversified across borders may find themselves being characterized as the new “AAA” sovereign risk. Bond investors could prefer these companies to highly indebted countries, whether developed or developing. Jargon or market conventions may eventually change from 100 over treasuries to treasuries 100 over multinationals.
• Real returns matter. Deflation and Inflation may be the opposite ends of the spectrum by which successful, long term programs are judged. For developed nations, we seem fixated upon deflation or low inflation and ignore that inflation has already risen in the developing nations creating medium term political risk. Our challenge is how to effectively incorporate this into portfolios. I believe this will be a consistent theme for some time to come and has the capacity, if not attacked within asset allocation, to cannibalize portfolios and threaten the ability to pay benefits or spending policy. We no longer live in a unilateral set of inflation or deflation assumptions.
• Fixed income perils, of course, are a bond geek’s paradise. The recent volatility on the long end of the yield curve dramatically and emphatically signals the end of the thirty-year bull market. The challenge to holding only nominal fixed income portfolios, as a result, moves up the list for similar reasons to currency. Over the longer term, portfolio implications are negative. Wise investors should be contemplating strategies to address the problem now. We are likely to transition into a world where developed market discount rates remain moored to the bottom of yield curves while the belly and the long end of the yield curves get more and more volatile as a way of signaling the sovereign risk of their issuers.
• Finally, an active management strategy to hedge uncertainty or “long/short moves into traditional space” is sure to be on the agenda of many investors. Governance is the key variable here, and this is a policy conversation which will have legs. Hopefully, when committees re-engage in the active/passive discussion, they will not only think about underlying investable universes, but also about how to migrate hedged strategies into core asset classes.

So, hats off to the groundhog, and may you have successful programs in 2011. Let’s get together at the same time next year to see how my list did.

Share

The continent of Africa is rich in resources and human capital, and through creative and diligent reforms enacted by member countries of the African Union, it has positioned itself well for future economic growth. While much of the media coverage of Africa focuses on a few war-torn or drought-ravaged countries, many countries in the region are beginning to enjoy the benefits of success. The Russell Frontier Index, with 41 countries and 678 securities, incorporates companies from within the growing economies of the Africa region, providing opportunity for investment in 11 diverse countries.

Learn more. Read the entire paper: The Frontier Markets of Africa

Share

Are you invested in Egypt?
If you invest in emerging markets, you are likely invested in Egypt which is part of a diversified Emerging Markets Portfolio. Egypt represents 1.2% of the benchmark MSCI Emerging markets Index.² So whether a portfolio manager decides to underweight or overweight the Egyptian market, the overall portfolio exposure is small.

What are the possibilities of contagion?
The ouster in Egypt follows on the heels of the Tunisia, which erupted in anti- government protests late last year and ultimately forced Ben Ali, then president, to flee to Saudi Arabia. Tunisia’s current interim government is attempting to transition toward a democracy³ and the Egyptian military is promising the same.

While the world digests the toppling of two repressive regimes in less than two months, regional neighbors (such as Bahrain and Yemen) are also witnessing the type of demonstrations that could lead to regime change.⁴ For investors, we emphasize that emerging market investing is more likely to be characterized by market disruptions than in developed markets and, such disruptions are marked by volatility. From a regional perspective, we also like to remind investors that there are 42 countries in Africa, some with stable democracies and good growth prospects.

Long term positives
From a long term perspective, the demands by an educated citizenry for a government more representative of its population augers greater stability and economic opportunities. While it is impossible to predict political outcomes, Russell anticipates that emerging economies will continue to offer attractive risk adjusted returns for long term investment and capital appreciation. Moreover, market pullbacks may be attractive entry points from a valuation perspective for long term investors.

Share

Share

In our Asia-Pacific Paper, you’ll see the incredible economic diversity of this region. Ranging from 73 constituent companies in Bangladesh to just one company in Kyrgyzstan, the frontier Asia-Pacific region offers exposure to countries and economies not captured by other Russell indexes. In the paper, you’ll see how the Asia-Pacific segment of the Russell Frontier Index was heavily skewed toward the Financial Services sector while the Health Care and Technology sectors are significantly underweighted. And it may come as no surprise that Asia-Pac is the highest-performing region in the Russell Frontier Index over our sample period (June 2007–September 2010).

Learn more. Read the entire paper: The Frontier Markets of the Asia Pacific

Share

This seemed at first puzzling. The mills in the area benefit greatly from economies of scale. Buying power, rationalization of business units, distribution leverage, and the efficiency of specialization – which lowers the frequent setup costs associated with lower-volume batch runs – argue strongly in favor of the business model of this mill’s former parent. Mills are generally more profitable when part of a large regional network of mills.

How would the mill fare better as an independent? I was told that the new management would chop away the bulk of its lower margin business and focus on the remainder with strongest profitability. This could be eminently sensible as a business strategy, but on the face of things it seemed odd.

Before passing judgment on the new owners’ strategy, many more questions should be asked. However this blog post is not about mill economics. Rather what stood out as interesting was the keystone to the entire deal: leverage. With little money down and with interest rates as low as they are, deals that seem to defy economics begin to make sense.

Capitalists are a canny lot when it comes to seeking profits. Private equity investors are no different. They make their money seeking assets to acquire for re-organization and / or disposition, usually with leverage as a funding tool. If one can borrow heavily in an environment where the Fed Funds target rates are effectively zero, one need only a slightly higher profit than one’s borrowing costs to yield a handsome return.

Example: Invest $20 million in capital. Borrow $80 million for a leveraged buyout of an enterprise. Pay 5% interest. Assume the enterprise returns just 7% on asset dispositions and on remaining lines of business. This leaves 2% net return on $100 million, which is $2 million dollars profit on a $20 million dollar capital investment – a return on capital of 10%. If you manage to scratch out 10% returns from the enterprise, you’ll have earned a 25% return on your capital!

Although this example ignores the tremendous risks of leverage, it does make it easier to understand what might otherwise seem a gravity defying business strategy. One doesn’t need to make much to make a lot in a levered world. And the helium that keeps leveraged strategies afloat is low interest rates.

Current Fed policy of easy monetary conditions (that is, low rates) is geared toward realizing higher employment levels and, on an unofficial level, stimulating higher levels of economic activity. Ironic that going forward, my friend’s former mill will be employing fewer people and making fewer goods.

Share

Share

In a U.S. region where snow is treated as a holiday for kids (and parents in most cases) it seemed unlikely cold weather would affect the Super Bowl. This seemed all the truer when eight days before the game, many of us were forced to run our air conditioners as temperatures passed 80 degrees in some areas. What followed a few days later was an Arctic cold front that kept North Texas below the freezing mark for days. Of course, the high and low temps are both possible for this part of the country. However, we usually don’t have thousands of national media members in town to report on our lack of snow plows and heavy winter coats. (Why these same journalists didn’t have access to weather.com is a greater mystery).

Also in the news during this time was the political unrest in Northern Africa as Tunisia and then Egypt have moved to political regime change. While these changes will certainly have long term effects and are “newsworthy” it might be prudent to note that both of these countries are considered emerging markets where many rational investors would expect a higher likelihood of such events than in developed markets. This isn’t to say they aren’t important or relevant, but to remind us that these things do in fact happen and should be expected to occur.

While not comparing the nuisance of an ice storm to the major concerns that Egyptians were facing, investors should be aware these events happen. Political unrest in an emerging market and a February ice storm in a southern state in the U.S. may not be the “Black Swan”¹ event some predict. Rational folks typically know the enhanced returns they hope for in emerging markets come with the expectation of higher risk. A trusted advisor can help investors stay focused.

As you face these events, maintain a conversation with your advisor and ask him or her how these events can impact your portfolio. Just as checking the weather before heading out can help you prepare for the elements, a conversation about your asset allocation can help you prepare for market events. And being prepared for how you handle these events can mean the difference between success and failure in investing. Sadly, my experience tells me no amount of conversation can bring the Dallas Cowboys back to the Super Bowl.

Share

Share

Dr. Wood, what’s the outlook on inflation mean for markets and investors?
As we said in our 2011 Outlook, Russell expects the risk of inflation in the U.S. to remain relatively benign. We think the Fed’s late-2010 quantitative easing will succeed in avoiding deflation. And with deflation mostly off the table, we also expect that core bond markets will experience a mild sell-off – the key word being mild. We project that 10-year treasuries will have a 3.75-4.0% yield. On the equity side, we expect 2011 returns in the high single digits to low double digits. And, if inflation continues to remain low, traditional inflation hedges such as commodities and real assets may be less appealing in the short term.

But look, none of this is a sure thing – especially in the short term. That is why at Russell we always preach broad diversification across all asset classes and styles. The best protection against inflation, deflation, stagflation or stagnation is a well-diversified, well-managed portfolio.

Read the full Professor Portfolio article ›

Share

In your opinion, what’s keeping inflation in check for the short term?
First, the historic shock to the world financial system in 2008 caused everyone (every person every household, every business, and every government) to have a higher demand to hold cash than they did three years ago. Recent studies have shown that in the U.S. alone, the global financial crisis caused over $1.3trillion in losses and write-down’s. (Europe has confessed to about $550 billion, but trust me, that European number is going spike – and a lot.) This has chewed up a lot of capital and collateral, and the Fed has had to replace that chewed up capital. It is essentially trying to fill a massive hole.

Look at the velocity of money – the rate at which money in circulation is used for purchasing goods and services. It is still at multi-year lows, all that “printed money” is just sitting there.

Velocity of money – United States

Source: Russell Investments, FactSet, OECD. As of 12/31/10.

Second, there is also an “output gap” that is still yawning – meaning that our economy is not operating anywhere near full efficiency. Jobs are still relatively scarce and wages aren’t growing very fast, so there’s just not enough demand for goods for companies to be reasonably able to raise prices.

Output gap & Inflation – United States (3/31/86 – 12/31/10)

Russell Investments. Data retrieved from FactSet and computed by OECD. As of 12/31/10.

While at Russell we are acutely aware of the consequences of high inflation – mostly because wages don’t rise as quickly as prices – right now we don’t see the case for runaway inflation as a near-term threat.

Tomorrow we conclude the inflation discussion with the outlook on inflation and what it means for the market and investors.

Share

Dr. Wood, can you briefly explain current Fed Policy?
Since 2008, the Federal Reserve has been pursuing what I call an “A.B.D” policy – or “Anything But Deflation.” Basically, the Fed has worked hard to avoid a Japan-like scenario.¹ Even though the odds of deflation continue to drop, its consequences would be catastrophic. So think of Quantitative Easing (QE) 2 ² as a $600 billion insurance policy that the Fed took out to insure against deflation. While inflation always needs to be a concern for an investor, we see any significant inflation occurring in terms of years, not months.

Thanks for that. What is Russell’s current outlook on inflation in U.S. markets?
Perhaps most interestingly, readers should know that we do not see a high probability of that late-1970s style of inflation – which I believe is most people’s fear. At Russell we expect that, while inflation expectations have risen in recent months, inflation itself will continue to be tepid in 2011. If you look at break-even rates (or the market expectation of inflation) it takes about six years for inflation to pierce the Fed’s stated target of a 2% ceiling.

U.S. Inflation Breakeven Rates

Source: Bloomberg, Russell Investments. As of 1/17/11.
Breakeven inflation rates are derived by taking the difference between the respective yield on the U.S. inflation protected security versus its comparable nominal U.S. fixed income security.

Essentially, we’ve moved from fears of deflation to concerns over modest inflation – and that (believe it or not) is an improvement and one of the Fed’s goals. For the rest of 2011, it’s a safe bet that the Fed will continue to worry equally about deflation and runaway inflation.

Why is the Fed trying to create some inflation?
The Fed thinks that reasonable inflation is “better” because it changes behavior. For example, if investors and consumers expect modest car price increases, consumers are more likely to buy a new car now when it’s comparatively cheaper – and investors are more likely to invest in car companies given increasing demand. If you think that housing and land costs will rise, then you’re more likely to invest in real estate. If you assume prices will drop, then you’ll probably hang onto your money. Markets want money to move. A reasonable amount of inflation makes money move and spurs investing. So the Fed is working to lower funding costs and to push inflation expectations (and thus behavior) positive – as part of that “A.B.D.” policy.

Check back tomorrow when Dr. Wood continues the inflation discussion with a look at what’s keeping inflation in check for the short term.

Share

By lumping everything together, the idea of “alternatives” as a single category can lead to investors failing to consider each idea on its own merits – and that can lead to poor investments by those too inclined to pursue every opportunity that can be labeled alternative, or to missed opportunities for those inclined to dismiss anything that carries the tag. The most skeptical individual I know when it comes to alternatives has argued in the past for writing call options in certain markets – but I’m sure he would have given them a grumpy “harrumph” if they’d been introduced to him as alternative investments.

The only justification for a “miscellaneous other” category is when each member of that category is small enough that it’s not worth calling out in its own. As interest in different strategies continues to grow, that’s simply not the case with alternative investments.

Share

Share

I will be glued to the TV as a 60-minute game determines my emotional state for the foreseeable future. If the Steelers win, a party will ensue! Should the Steelers lose, there will be a slow, painful recovery before I feel better.

Often I contemplate how much I’d be willing to pay to ensure my Steelers win a big game like this upcoming Super Bowl. Although I don’t have an answer yet, once I do, I plan to take that money and bet it on the Packers. To sports fans this may sound like sacrilege, but hear me out.

Right now I have so much riding on one outcome (Steeler win) of an uncertain event (Super Bowl) that hedging my position makes sense. If the Steelers win and I lose my bet, it’s fine because I would’ve paid that much to ensure the win anyway. If the Steelers lose, at least my recovery will be subsidized by gambling winnings.

Sponsors of defined benefit (DB) pension plans find themselves in similar situations each year. Instead of having a large emotional stake in the Super Bowl, sponsors participate in another contest with an uncertain outcome: the Interest Rate Game.

Current market interest rates must be used for valuing pension plans under today’s funding (PPA) and accounting (IAS/FAS) regulations. Unfortunately, these rates are very volatile and unpredictable from one year to the next.

If interest rates rise during the year, plan sponsors “win” and their DB plan liability drops. However, if these rates decline then the opposite happens and the liability grows. This can have unfavorable consequences for sponsoring organizations:

• Larger cash contributions
• Drop in shareholder equity on balance sheet
• Future earnings dragged down by higher pension expense

Most sponsors don’t like the sound of that! Sponsors are constantly “rooting for” interest rates to rise.

The pension equivalent to betting against my own team is investing the plan’s assets in investments that also change in value when interest rates move, most commonly long duration corporate and government bonds.

Many plan sponsors maintain that now is not the time to shift assets into interest sensitive investments. This argument is based on the expectation that interest rates will go up soon (like what happens between years 2 and 3 of Exhibit 1). The problem with this thinking is that sponsors are still placing significant bets on one side of an uncertain event without a hedge in place. Just because I honestly think that the Steelers are the better team, doesn’t mean I’m not going to hedge against them losing!

Regardless of where interest rates go, there are steps sponsors should take to begin hedging against interest rate movements (so the funded status progression looks more like Exhibit 2). Setting up a hedging strategy now is as good a time as any!

Go Steelers!

*Graphs above are hypothetical analysis provided for illustrative purposes only.

Share

In keynote speeches at Davos on Friday from U.S. Treasury Secretary Timothy Geithner and German Chancellor Angela Merkel, I heard pronounced attempts to reassure the markets that the weather in their respective parts of the world is indeed improving. Mr. Geithner delivered strong rhetoric about America’s prospects to deliver fiscal responsibility and contain its outstanding debt, but also recognized the challenge of achieving the political will to address the nation’s long-term deficits. While he espoused that Congress would do the right thing, he provided very few specifics about exactly what that would entail, and ultimately he fell somewhat short of swaying his audience (and quite possibly the markets too given Friday’s closing numbers).

Meanwhile, Ms. Merkel made it clear that there is an absolute determination in Europe to defend the Eurozone. To emphasize the solidarity that exists among the nations there, she repeated some of the same phrases from President Sarkozy’s remarks yesterday, noting that “The Euro is Europe.” She also went to great lengths to point out that the same standard of fiscal prudence and competitiveness was going to be required of all countries in Europe going forward. In other words, the quid pro quo for support will be reform.

Moving south on the weather map to Africa, I attended a fascinating breakfast on Friday with former UK Prime Minister Tony Blair, Harvard Professor Michael Porter, a host of CEOs and President Kagame from Rwanda. In a variety of guises over the last several days, I have seen great confidence around the rebirth of Africa and the frontier market opportunities it represents. Rwanda is an exceptional example of that, having rebuilt from the genocide that took place there in 1994, and illustrating what the benefits of good leadership can achieve even in the most presupposing of circumstances. Despite the fact that Rwanda is landlocked, it is something of a gateway to East Africa and its 100 million people. As a result, there is growing interest in Sub-Saharan Africa among private equity investors, the IFC at the World Bank, and others. This is an inspiring story – not just for investors, but for the whole world.

Building off the subject of making the world a better place, I’ve attended several sessions at Davos on the topic of responsible investing – an issue close to Russell as one of the signers of the United Nations’ Principles for Responsible Investment. On the heels of a report just issued by the World Economic Forum, there was a lively debate – but no real consensus – about exactly what responsible investing means around the world. When everyone has their own interpretation, it creates difficulties for investment managers like Russell to implement. Still, we were able to classify four broad categories of responsible investing, which is progress. And most important, there is a strong alignment of intentions and a great willingness to keep the conversation going.

That, for me, captures the spirit of Davos. By coming together in common cause, we can make a difference. As one, we can aim for blue skies around the globe.

Share

Share

The issue of the valuation of the Chinese Renminbi (RMB) came up in several of the sessions I attended today, and it’s fair to say it was hotly debated. A number of American commentators were vocal about the impact that Chinese currency manipulation has had on the U.S. economy, while much of the rest of the world believes a revaluation of the RMB would have only a marginal impact on a U.S. recovery.  The core question: Is the trade imbalance between the U.S. and China the cause or effect of an undervalued RMB?

How the U.S. ultimately chooses to answer that question is critical because it could inform where the focus is leveled in the effort to improve the American economy. Of course, depending on which economist you’re talking to at Davos, you could get very different views of what the U.S. economy is poised to do next. Normally, the consensus regarding GDP growth is reasonably stable, but there is widely disperse views now. Following one argument, we are seeing improved economic output in the form of orders, exports, profitability, etc. That could lead to a recovery in housing which could lead to a more consumer spending. Following the wholly opposite argument, we are seeing a stagnant American economy today in the form of unemployment, loan defaults, and contraction of state and local government. This could lead to a second round of a housing crisis, less consumer spending and a spin downward in economic output. It’s the same cycle with two plausible but opposite views. The only certainty:  we are poised at a very delicate moment with a wide range of possibilities ahead.

In the midst of all these unanswered questions, President Clinton made a very statesman-like intervention. He weaved together several global themes, and urged accountability, responsibility, and what he calls “Communitarianism” between and within nations. He made the case that it is hard to find successful countries around the world where substantial inequality – in income and otherwise – exists. It was an outstanding message to end the day on, and a good reminder why we come to Davos in the first place – not to air our differences, but to work toward what we share; to improve the global community.

Share

While emerging markets continue to do well, they remain vitally linked to the U.S. and Europe, where substantial imbalances — in areas such as the housing markets — need to be worked through before the global crisis is truly over. Genuine transformative change has to occur, and there is speculation about whether or not the U.S. and Europe have the appetite to make some hard decisions.

Europe and the UK have dealt with their fiscal imbalances more directly than the U.S. There is a sense of inevitability that issues with the Euro will have to come to a resolution, likely with one or more technical defaults, and possibly through some sort of voluntary mechanism. It remains to be seen, though, whether or not this would take place within the Eurozone or if countries could possibly be expelled from it. Based upon what I’ve heard from the speakers at Davos on Wednesday, there appears to be a distinct political desire to maintain the Eurozone.

In the U.S., the road to broad recovery is even less clear. With unemployment at levels not seen since the Depression, and an absence of consensus among politicians regarding how to address job creation, it is difficult to see how a solution could come quickly. That said, there was quite a bit of discussion at Davos about President Obama’s State of the Union address on Tuesday night. He received praise for recognizing the problem directly, and for his call to action to re-shape the U.S. economy with an emphasis on innovation. While the consensus was that his speech lacked specifics about exactly how that can be executed, most agreed it was a step in the right direction. And at Russell, we are eager to play a role in developing some of the innovations for that new economy.

Share

The earnings season is upon us. In the latest Market Week in Review, Russell’s Erik Ristuben explains his point-of-view that for stocks to grow in value, we’re going to have to see strong earnings reports from companies. Erik thinks that’s precisely what we’re seeing. Watch now for further thoughts on earnings, housing inventories and a summary of the outlook for 2011.

Share

For the investor convinced that the glory days of bonds are over there are simple reasons to feel this way. Nominal yields have been very low for quite awhile. Compounding the effect of these low yields has been the rather large amounts of capital being poured into fixed income markets as investors chased the large returns of the last few periods. That these returns, in the relatively safe world of bonds, were artifacts made possible only by severe pain felt by bondholders during the economic crisis was lost on many of these investors. Sadly, these efforts are beginning to look painfully like the mirror image of what often happens late in equity market runs. But what about the asset allocated investor who holds fixed income in a period of rising interest rates?

First, it should be noted that good asset allocation discipline requires to hold asset classes when it “everyone knows” they should be sold. For example, it was clear at the end of 2008 that emerging markets and real estate would not be attractive for several years to come yet the timing of a great drummer they of course had outstanding performance in 2009. This may well be the case with bonds as timing the direction and speed of interest rates is very difficult. In fact, consistently allocating a portion of one’s assets to fixed income, even in periods of rising rates, can lead to positive returns. However, there is a difference between asset allocation and timing the market.

We could forgive the asset allocated investor for not understanding all of the noise about the bond markets. After all, just as their fixed income allocations may have struggled they are likely seeing positive returns in their equity allocations. In fact, despite all the media driven hyperbole the bottom line of their statement may have grown significantly. This is the way asset allocation is supposed to work – quietly allowing clients to stay invested in the asset allocation they, in conjunction with their trusted advisor, determined was the proper mix to reach their goals. It isn’t exciting but just as eating your vegetables and exercising improves your chances of good health, so does maintaining the correct asset allocation increase the odds of reaching your goals.

Of course, there are no guarantees of what bond markets will do over the next several days, months or years but it does seem logical that owning fixed income as part of a well thought out asset allocation will be important to investor success. It won’t always be fun and exciting but it is worth considering. Now about that broccoli…

Share

Consumer Price Index reports are in. On the latest Market Week in Review, Erik Ristuben, Russell’s Chief Investment Officer, Client Strategies, shares why he thinks a little inflation is a good sign for the economy. Eric also weighs in on earnings reports from Intel and JP Morgan and what those reports might mean for the growth of stock values for 2011.

Share

The “to” camp is characterized as a proponent of the idea that target date funds should be designed primarily to build savings up to an individual’s target retirement date. Thus target date funds that have a more conservative allocations to stocks (or other risky assets) at an individual’s target retirement date, typically with a flat or static allocation during later retirement years, are often put in the “to” camp. In contrast, the “through” side has been defined as those who believe target date funds should be designed to help investors save through retirement. Target date funds with higher allocations to stocks at an individual’s target retirement date and with a declining allocation to stocks for 15 to 30 years after retirement, are often put in the “through” camp.

Russell has written extensively about this topic (see The date debate: Should target date fund glide paths be managed “to” or “through” retirement?), and like many others we have suggested that this distinction fundamentally distorts the glide path issue and prevents the industry from having a more responsible discussion.

The danger of over-simplification
In order to make satisfactory decisions, human beings often want to limit and simplify the choices they need to make. Thus, we are often asked to choose sides based on general classifications: Conservative or Liberal? White wine or red? Beta or VHS? (Okay, that one may have been more relevant in 1983.)

The industry has similarly simplified the choices that plan sponsors need to make. Active or passive? Off-the-shelf or custom? Proprietary or open architecture? Basic asset classes or alternatives? We have done this with the glide path design decision as well.

But are we doing a disservice to the fiduciary process by making it seem so black and white? In other areas of defined contribution plan design, we do want to make choices for the participant simple. Yet should that also apply to target date fund selection?

If not, it seems we need to rename the “to versus through” debate, or maybe kill it all together. As I see it, there are really three main issues wrapped up in this debate:

1. Do you believe that the glide path should consider what an appropriate post-retirement asset allocation would be for someone who stays in the plan? (Note: if your answer to this is no, then you may want to select a fund whose asset allocation takes all risk off the table at retirement. If not, you should answer questions 2 and 3.)
2. From an investment perspective, should the post-retirement asset allocation be static?
3. What is the right level of investment risk at and into retirement?

For example, in target date fund design Russell advocates for a more conservative and a flat asset allocation after retirement, so we’d answer “yes” to question 2 and “lower risk” for question 3. So, you might think we’d be in the “to” camp. Yet our research suggests this is the better way to get investors “through” retirement and thus our answer to question 1 is “yes” as well. In fact, we think any glide path manager who considers the post-retirement investment strategy should be considered a “through” manager.

While you might not think this decision matters much, 2008 showed us it can have a major impact. For example, the Morningstar universe of 2000-2010 target date funds had a range of returns in 2008 from -3.6% to -41.8%.¹ That caused many to scratch their heads and ask “How could strategies designed for the same person have such different results?”

It takes some time to think through these questions. But there is enough research out there to help plan sponsors make the right decisions and they owe it to plan participants to do that extra work.

Share

It’s not a game to be taken seriously, the game of predicting the future. But it can be useful, as long as we use it to broaden our grasp of what is possible rather than to reinforce a narrow view of how uncertain the future is. It’s a good idea to ask from time to time “what might we be missing?”

So, let’s play. Will the investment conversation of 2011 continue to have an economic focus – a continuation of the story of double dips or recoveries, of inflation and QE-whatever-we’re-up-to-now? Will the price of oil come back to be top-of-mind again? What about other commodities? There are rumblings about copper – and who foresaw a year ago that a hedge fund would try to corner the cocoa market in 2010? Or will it turn into a political conversation – regulation, reform, taxation or protectionism, perhaps?

There does seem to be a good chance that there will be a lot said about fixed income investment this year. But it’s not going to be enough to talk about whether interest rates move up or down; it’s going to be a more nuanced conversation than that. Treasury yields may move one way while corporate bond yields move another. Long bonds may behave differently than short.

As for equity markets, will they calm down? From 2004 to 2007, there was not a single month in which the U.S. stock market moved up or down by more than 5 percent. In 2008, 2009 and 2010 there were more months (19 of them) when that happened than months when it didn’t (as measured by the total return on the Russell 3000® Index).

And will attention focus on a “least ugly contest” among major currencies, as many are suggesting? If so, is the U.S. dollar the most likely winner? Or will it be a different currency that dominates the conversation (such as the bookmakers’ current favorite: the euro)?

Or do we need to look elsewhere for the big story? Scandals or terror? New wars beginning or old ones ending? The list of stories that could happen is endless. Maybe the safest bet for the biggest story is the old standby: “none of the above.”

But whatever 2011 holds, and whatever the conversation turns out to be, all of us at Russell wish you the very best of health, prosperity and happiness. Happy New Year!

Share

On this week’s Market Week in Review, watch Russell’s Erik Ristuben give a quick comparison between the year behind and the year ahead. 2010 ended astonishingly strong. Equities had a positive year relative to fixed income and, as Erik said, fixed had a pretty good year. So what’s in store for 2011? Find out Russell’s thoughts for this year’s U.S. GDP growth and equity performance.

Share

Indeed, it’s the rare fan that looks first to the play of the offensive and defensive lines for the keys to the game. This same pattern often holds true for investors in considering the complexities of understanding multi-manager funds.

While any offensive lineman would certainly stand out in a crowd, their similarities end at first glance and it is their unique skills that make them a center, guard or tackle. These skills are similar to the view of a manager in Russell’s multi-manager funds. While any given manager may focus on growth investing (typically buying stocks that are expected to have better than average growth rates), they all play a part in helping accomplish the goals of the fund. Just as with the linemen, it is this coordination of the managers that allow progress towards the end goal.

This analogy can be further drawn to the overall asset allocation of any given client. While asset allocation can reduce the volatility in a portfolio, it also offers the opportunity to potentially outperform single asset class bets. Simply stated, when an offensive line or a multi-manager fund is maintained with thoughtful coordination, the odds that the team or the client will cross the goal line are increased.

As important as this coordination is, there still has to be a coach that organizes the team and calls the plays. Ideally, this coach inspires faith and determination and brings critical decision-making skills to the table. For investors, this coach is usually their wealth manager. No matter how well an investment portfolio performs, investors need their wealth managers to enforce rigor and maintain the course on an investment strategy to be successful.

Just as the end of the year and the arrival of bowl season bring hope and uncertainty to every football team, investors also have an opportunity to consider their investment strategies and refocus their attention on achieving their end goals. There may be no better time than the present to meet with your wealth manager to review your financial game plan. One thing is clear: staying on the sidelines is the one decision that could prevent investors from crossing their financial goal line.

Share

In “phase two” of globalization, there are a number of structural changes taking place: China joined the WTO, the global outsourcing and commodity booms are in full effect and China is now the largest owner of U.S. Treasuries and may float the Renminbi (or allow it to fluctuate according to the foreign exchange market). And these structural changes have had implications on markets. In particular, emerging markets have continued to rise as a percent of the opportunity set and we expect this story to continue to play out in the coming years.

Right now, emerging markets make up only 14 percent of the Russell Global Indexes. However, Goldman Sachs projects that emerging markets will represent 31 percent of the equity markets in 2030.¹ This makes sense when we dig deeper into the statistics beyond indices.

Looking at market cap unadjusted for free float (i.e., including privately held shares of public companies), emerging markets represent more than 27 percent – almost double the float-adjusted 14 percent in the Russell Global Indexes. Population and GDP figures point to even further scope for a shift towards emerging countries. Emerging markets’ year-over-year population growth is 1.2 percent, compared to 0.5 percent for developed markets. The emerging markets population is now over 86.5 percent of the total world population, and 83 percent of the total employment.²

What I find even more interesting is the shift in dynamics that speak to innovation, such as R&D spending and patent filings. In 2009, 30 percent of global patents originated in the United States – representing the largest proportion of any country. However this is does not align with the U.S.’ 41 percent market cap, and countries like China and Korea are growing slices of the pie.³

Anecdotally, one can gain an even greater appreciation for the rise of emerging markets in R&D spending by considering the example of Applied Materials, a U.S.-based company that produces semiconductor and solar components. In 2009, the company was preparing to open an R&D plant and narrowed the search for employees to the U.S. and China. In China, when they floated the jobs in the market, the center received 26,000 Chinese applications and ended up hiring 330 people – 31 percent with master’s or Ph.D. degrees. China has 75,000 advanced degree grads each year and India has 60,000; this is a rising pool of talent that speaks to the future of those societies.⁴

There is no doubt that globalization has begotten dramatic changes in the world’s equity landscape. In general, investors have been slow to react to these changing dynamics within the global equity market place. But now more than ever Russell believes it is important to adapt portfolios to where the world is going – whether it be emerging markets, frontier markets or other areas of growing interest – not where it is today.

Share

Russell has done extensive research on the “sustainability” of spending in retirement and we have run simulations to estimate the probability of spending rules lasting a lifetime. The probability of success for a particular spending rule depends, of course, on the expected returns of asset classes. The higher the returns, the higher probability of success.

In March of 2010, Russell’s expected rate of return for U.S. equities over 20 years was approximately 8.2 percent on an annualized basis; the expected rate of return for U.S. fixed income was 5.2 percent. With those assumptions, the probability of success for the Golden Rule (where we set the “moderate” portfolio at a 40 percent/60 percent mix of equity and fixed income) was 85 percent.

By June 2010, those expected rates of return had dropped to 7.8 percent for equities and 4.4 percent for fixed income, and the probability of success had dropped to 78 percent. While it’s a matter of personal opinion whether this reduction is a serious problem, it is clear that this reduction in return expectations has a material impact of the probability of success of the Golden Rule.

So what can be done? One course of action is to reduce spending – maybe lower the Golden Rule to 3.5 percent of the initial retirement wealth to restore the 85 percent probability of success (assuming that was acceptable to begin with). However, that is a material decline in spending. If you were living off of $80,000 a year at 4 percent, your new retirement income would be reduced to $70,000.

Another possibility is increasing risk in the portfolio by increasing the allocation to equity, which isn’t a particularly appealing solution. Typically, for “high confidence” spending rules like the Golden Rule, increasing the allocation to equity beyond a certain level reduces the probability of success.

There is another way. It is possible to manage the investment risk of the portfolio more carefully to control the spend-down of capital. This can be done with dynamic asset allocation methods that adjust the allocation in response to the funding status of the spending plan. Essentially, these dynamic methods are designed to reduce risk in the portfolio if bad market outcomes threaten the viability of the spending plan. And these strategies are available in the market, such as the optimized dynamic asset allocation process Russell employs in some of its products.

With current levels of expected returns, the Golden Rule is certainly debased. With simple static asset allocations, the choice is unpleasant – withdraw less and accept a lower standard of living, or increase the risk of running out of money. Dynamic asset allocation methods can improve this situation.

Share

Check out a recent Investius.com Financial Thought Leaders report featuring Russell’s Chief Investment Officer, Client Strategies Erik Ristuben’s thoughts on the topic.

Share

As the holidays roll out, one figure that may come to mind is our greedy old friend and antithesis to the Christmas spirit, Ebenezer Scrooge.

By making Scrooge a banker, Dickens painted in broad brushstrokes a popular portrait of greed that persists to this day. In the early 21st century there is no shortage of association between finance and greed. (See the fourth quarter 2008 spike in “greed” as a news item in the Google Trends chart). Many blame the banking and credit crisis that came to head in 2008 upon the “unbridled greed” of our banking system:

“Greed is bad.” — Paul Krugman¹

“[T]he root of [the financial crisis] is human greed.” — Rowan Williams, Archbishop of Canterbury²

“These [Dodd Frank] rules will… crack down on the culture of greed and scheming that has led us to this day of reckoning.” — President Barack Obama³

Greed is much used and yet ill-defined, making it a great rhetorical connector but a poor tool for illuminating an issue. Was it indeed a spontaneous wave of banker greed that was at root of the Global Financial Crisis? The question won’t be settled here, but this post will attempt for it at least better definition.

What greed is
In the vernacular, greed can mean the desire for too much or it can be used to mean excessive ambition. Greed and selfishness are often seen as interchangeable; even greed and self-interest are inextricably linked in the popular mind. The ambiguity of usage muddies the waters where clarity is needed.

Here is a definition that differentiates greed from the many other human traits for which we have better words: Greed is the desire for the unearned. To be clear, “unearned” means “not voluntarily given, exchanged or traded.”

When defined as such, no arena of human action is exempt from greed. Finance is no more deserving the negative connotations than, say, politics or car building or long shoring. With a clear and discrete definition greed can be sorted from the many other behaviors, some beneficial, for which greed is often incautiously associated.

What greed is not
Greed is not ambition. Ambition, within the accepted laws and morals of a society, can be a powerful and constructive force. Equating it with greed is giving ambition, an otherwise productive trait, a bad name.

Greed is not the desire for too much. We have words like gluttony and avarice for that. When greed is used as a synonym for excess, such as an excess of salary or bonus, the subjectivity is inescapable. “Too much” is unworkable as a standard for public policy, and political attempts to define and limit “too much-ism” will fail to prevent another financial crisis.

Oliver Stone, when scripting Gordon Gekko’s famous speech in Wall Street, muddied the waters. What was so unexpected and memorable about the Gekko speech is its recognition of self-interest as a driving force for good in society, specifically for bringing shareholder discipline to corporate governance. For moviegoers who never picked up The Wealth of Nations or Ayn Rand’s Virtue of Selfishness, this was a new and provocative idea.

Self-interest is a primary motive for human beings. We implicitly know self-interest, we work with it, and we benefit from the self-interest motive when we cooperate and trade. Yet because of its poorly articulated association with greed or with greed’s similarly short-sighted cousin, selfishness, we are suspicious of self-interest and expend a tremendous number of words deploring it in others. We recognize the right of people to make money, yet we tend not to trust those who are too good at it. Contradictions and confusion reign.

And so, we must strip greed bare to its essence: the desire for the unearned. With definitions clear, can greed be blamed for the Global Financial Crisis? The answer depends upon one’s views on backstopping investors and speculators with taxpayer money.

Back to Scrooge. With better definitions at hand and no evidence that Scrooge was a cheat, we would do better to describe him as miserly rather than greedy. What is ironic is that old Scrooge, whom we imagine was a wrenching, grasping saver and coveter of safe returns, most likely wouldn’t stand for saving others from their greed at his expense.

Source: Google Trends. Data as of Dec. 15, 2010.

Share

Share

It’s the last Market Week in Review for 2010. Erik Ristuben, Russell’s Chief Investment Officer, Client Strategies, looks back on what he feels was an unsurprisingly positive 2010. And he looks forward to a 2011 that includes a projected 2.7% GDP increase, projected high-single-digit returns for equities, and continued focus on policies in Europe and the U.S.

Share

The reason that accounting for pension expense is tricky is that pension plans such as Honeywell’s have substantial sums invested in the stock market, and the stock market is a volatile animal. If a pension plan makes a big gain, then that means the corporation will have to contribute less in future, so the corporation is better off even though the gain occurred in the pension trust (a separate legal entity from the corporation).

The reverse applies in the case of a big loss. But what is the best way to recognize that gain or loss in the corporate earnings statement? If Honeywell’s $13.7 billion of pension assets earn just 1 percent more or less than expected, that represents a $137 million unexpected gain or loss – so the normal year-to-year fluctuations in market returns would be enough to make interpreting the earnings statement rather difficult if the gains and losses were to be lumped in along with everything else.

The traditional answer for U.S. corporations (ever since Financial Accounting Standard #87 was published in 1985) is to squeeze the gains and losses through the earnings statement over a period of several years, using a number of averaging techniques along the way so as not to disrupt the earnings statement too much. But that’s complex and opaque and the numbers it produces don’t mean a great deal. It’s long been recognized that change is needed.

What Honeywell have said they will do instead is to take these unexpected gains and losses and account for them fully (well, almost fully) in the year they occur – but they’ll put that in a special line in the earnings statement, keeping them separate from the operating earnings number that tells us how the core business has done. This is permissible under current accounting rules (even though nobody else does it that way).

It’s hard to say how many others will follow Honeywell’s lead. One reason is that there appears to be change on the way in the accounting standards themselves, so some may prefer to see what change is prescribed, rather than make a move now and then be required to shift again in a few years.

Others may decide to cast off the shackles now (and now may be a good time to do this, if interest rates really are primed to rise, as many expect), since the broad principle that Honeywell have adopted – marking to market, but keeping the gains and losses in a separate part of the earnings statement – is the principle that the revised standard is expected to be based on.

Fun times in the pension accounting world.

Share

Check out EriK Ristuben on the latest Market Week in Review. Russell’s Chief Investment Officer, Client Strategies, takes a look back on the last three months of bond-versus-equities performance. According to Ristuben, the short story is that while bonds still played an important hedging role, equities typically outperformed bonds. Watch now.

Share

Strong market performance bumped the European banking crisis out of the spotlight this week. According to Russell’s Eric Ristuben, Chief Investment Officer, Client Strategies, the market even shrugged off today’s “not even remotely good” employment numbers. Watch this week’s Ristuben: Market Week in Review to see why Eric thinks we may be in a heads-we-win-tails-we-win situation for the last month of the year.

Share

Russell’s director of Client Investment Strategies Erik Ristuben talks to host Kate Stouffer about the effect of QE2 on Treasuries, the Fed’s intentions to raise expectations of positive inflation and whether or not QE2 was even necessary. He also explores resurging concerns about investing in the eurozone. Tune in to this week’s Market Week in Review episode to get the details.

Share

Despite the lackluster week in the markets last week, Russell’s Director of Client Investment Strategies Mark Eibel tells host Mark Soupiset that it really had nothing to do with a post-election hangover and everything to do with things like the G20 meetings, troubles with the U.S./Korea trade agreement and bellwether earnings. Tune in to this week’s Market Week in Review episode to get the details.

Share

On this week’s Market Week in Review Russell’s Chief Investment Officer, Client Strategies Erik Ristuben talks about the market’s big week, quantitative easing Part Two, and how much the U.S. election results were pre-baked into market returns. Earnings season and sentiment around the double-dip are also on Erik’s mind this week. Be sure to watch this week’s episode.

Share

Be it in stocks, bonds, real estate, or currency, the financial markets have had a wild ride these past two years. Much of the volatility hangs on the uncertainty over the fallout from government policy decisions. Is the government spending too much, killing growth? Or is it spending too little, and not doing enough to stimulate output? Are interest rates too low, hurting the dollar and investment levels? Or is a weaker dollar a good way to boost exports and growth? Models exist that can help provide perspective for those questions.

There is one textbook Econ 101 model for the economy that helps to clarify many policy questions. Called the expenditure model of accounting for national income, it goes as follows:

Y = C + I + G + NX, where

Y = national income (or GDP, depending upon your textbook’s authors)

C = private Consumption, or private expenditure

I = Investment

G = Government expenditure

NX = Net Exports, or exports minus imports.

What this model offers is a neat demonstration that, for a given level of GDP, there is no free lunch. In a given slice of time the economy is zero sum, where one factor necessarily grows at the expense of another. ¹

Say that if you want to grow consumption (C), you can try to boost consumer demand by say, giving a one-off tax rebate. However that boost in demand must come at the expense of investment (if funded by government deficit borrowing), government expenditures, net exports, or some combination thereof. And so on for all the factor inputs.

So far, so helpful. Yet a funny thing about models – especially economic models – is that they necessarily omit information. A model is not a model if it does not strip away details, laying bare what one hopes is a telling essence. The more relevant the information retained, the better the model. But even the best models can leave out critical details.

So what’s missing from the national income model?

Three important elements are left out of this model. The first is time. Rates of change are of critical importance for investors looking to find from where the growth will be coming. Just as the real story can be read from company balance sheets by calculating the deltas over previous periods, the national income equation tells more when it is observed over multiple periods.

Second, and more controversial, is that if introducing an element of time, we should also add coefficients to the variables in the model. Work by Harvard professors Alvesina and Ardagna demonstrate that, far from being a static zero sum product, decreases in government (G) can lead to increases in Y (GDP) over time. In other words, government (G) should have a coefficient with a minus sign. Harvard’s Robert Barro demonstrates that rather than acting as a multiplier, as is commonly believed, fiscal stimulus can be a way of spending a dollar to receive eighty cents’ worth of output. When interpreting policy effects on the investment climate, this is helpful to bear in mind. For investment (I), it is reasonable to posit a greater than unity coefficient, meaning that for every dollar invested one should expect a boost in national income by an amount greater than one dollar.

Finally an all important fifth contributor to national income is missing from the expenditure model, entrepreneurialism². At Russell we would brand this as Innovation, but the idea, as expressed in international studies such as the Global Entrepreneurship Model, is the same: entrepreneurialism is the dynamic element of experimentation, adaptation and change which is essential for the realization of economic growth.

While one might argue that entrepreneurialism is embedded already in investment (I), it illuminates when distinguished from the restocking of inventories and adding of new production lines that are normal investment (I). Entrepreneurialism, in the Schumpeterian sense, is the force of creative destruction that drives economic growth and is increasingly recognized as vital for national income growth in development literature. Entrepreneurialism (E) is the difference between a hard working yet stagnant command economy, and one where the revolution in social structures is institutionalized. So an embellished model for national income might look like this:

∆Y = C + (1.06 x I) + (0.8 x G) + NX + E

Breaking it down:

GDP (with the variable of time in place)
=
Consumption
+
Investment (with an assumed 6% average rate of return)
+
Government expenditure (with only 80% efficiency, due to a 20% deadweight loss)³
+
Net Exports
+
Entrepreneurialism

What this offers are a number of test questions when a policy proposal is made. Which sector of expenditures will be most likely to grow as a result of the policy? Will this, over time, be positive, negative, or neutral for growth?

One hopes that the national expenditure model has done what models are supposed to do – bring insight and clarity to a complicated reality. In both its textbook or this modified form, the model should provide better perspective to the investment implications for the many policy proposals presently afoot.

Share

On this week’s Market Week in Review Russell’s Chief Investment Officer, Client Strategies Erik Ristuben provides perspective on the latest GDP number and why the market ignored it. Ristuben also shares his views on the anticipation surrounding the election and Federal Open Market Committee meeting outcomes.

Share

Models are how we make sense of a complex world, stripping a decision down to its core elements. Good models tell us something about how the reality on which they are based will behave, even though they are not themselves that reality.

However, there’s a danger in every model. It’s summed up by a quotation from George E.P. Box, who said that “All models are wrong, but some are useful”.

A model might start out as a useful way to represent the world and people start to rely on it. But then something bad happens: they over-rely on it. They forget to question whether it still applies, whether it might be leading down a wrong path in some new situation. The model fails.

Hence my advice to our institutional clients: don’t marry a model. Don’t become too attached to one way of looking at the world, one way of measuring risk or any one other way of analyzing a situation. Many of the investment disasters and failures throughout history can be traced back to failure to adhere to this advice.

Share

Third quarter earnings reports are out. On this week’s Ristuben Market Week in Review, Erik Ristuben shares how each of this year’s first three quarters have beaten earnings estimates. Based on leading economic indicators, Russell’s Chief Investment Officer, Client Strategies, thinks this growth is sustainable. Watch now and see why he also thinks the market is bullish on expected mid-term election projections.

Share

Mixed feelings

• Unemployment rate–, as reported by the Bureau of Labor Statistics, is 9.6% and barely lower from its peak of above 10% in late 2009. On the positive side: Initial jobless claims and continuing claims are starting to show slight improvement. Moreover, job creation, while modest, has advanced in recent weeks.²
• For homeowners, the news is gloomy: foreclosures have spiked and price values are improving at a slower pace. A sizable minority also owe more than their home is worth. For those looking to purchase a home, the future looks bright: housing prices appear to be stabilizing and affordability is high. Mortgage rates are at historic lows. Housing construction, while still is at very depressed levels, has improved somewhat in the past few months.³
• Consumer confidence levels are lower at this point in the cycle than previous recoveries, dragged down by unemployment worries and loss of net worth. Nevertheless, the most recent consumer confidence reading was higher than expected at 68.4. More good news is that consumers have begun to pay down debt and savings rates are up to 6% levels.⁴
• GDP growth is tepid with the second quarter measuring a 1.7% annual rate as recently announced by the Bureau of Economic Analysis on September 30th³. From a glass half full perspective, the latest leading indicators indicate stronger future growth as they rebound from low levels. A robust stock market also seems to indicate better times ahead. The Dow Jones Industrial average had its best September in over 70 years⁴ The Russell 1000® Index was up 9.19% including dividends, the highest September return since 1979.
• While consumer spending declined during the recession, both personal income and spending have begun to revive and slightly exceeded expectations last month as evidenced in recent consumption expenditures reported in the latest GDP release⁵. The International Council of Shopping Centers forecasts that U.S. holiday sales may climb 3-3.5% which bodes well for the stock market which is highly correlated to holiday sales⁷.
• Manufacturing is slowing from robust levels earlier in the year but the Manufacturing Institute for Supply Management still confirms that economic activity in the sector continues to expand at a moderate pace.⁸ Also positive is the recent Service Purchasing Managers Index report which highlights growth in the non manufacturing sector at a higher rate than expected⁹.
• It is disconcerting that $1 trillion in excess reserves in the banking system might soon be judged insufficient to keep the economy from slipping into deflation, thus making further asset purchases by the Fed likely. On the bright side, the Fed stands resolute to keep the economy from slipping into a double dip recession, as recently noted by William Dudley, Federal Reserve Bank of New York President.¹⁰
• Gold, which is generally seen as a safe haven from inflation and a weak dollar, reached a record $1,350 level per ounce on October 6th and continues to climb in its longest rally since 1920¹⁰ While gold has become a proxy currency for those who fear inflation and international instability, typically the positive result of dollar weakness is that U.S. exports become more attractive.
• Cities, states and governments are debt ridden from spending funds that they do not have amidst falling tax revenue and stimulus programs. Overall however, the worst seems to have passed. Tax revenues inched up in the second quarter.¹¹

Stealth improvements point to better days ahead?
Despite the sobering backdrop of the Great Recession, we note that in multiple cases the sequential improvement in key data – albeit muted – corroborates a healing economy. While there is room for improvement, the much discussed “soft patch” and fears of a double dip recession are receding. The question is really how long it will take to return to normal growth rates from sub optimal?

Feeling better
Investors have piled into what some may consider safe havens of gold and treasuries. However the robust advance the equities markets may reveal a vision of better days. Russell anticipates stealth improvements becoming more apparent – especially after the uncertainty over upcoming elections and policy issues is resolved. Things are not as bad as they were. It may be time to feel better.

Share

Watch this week’s Ristuben Market Week in Review, and you’ll learn how markets are responding to up-news in tech stocks and down-news in financials. Erik Ristuben, Russell Chief Investment Officer, Client Strategies, also gives his take on the current foreclosure situation. And he explains why a strong yen may be bad news for Japan, while a weak dollar may be good news for the U.S.

Share

On this week’s Market Week in Review, Russell’s Chief Investment Officer, Client Strategies Erik Ristuben shares his perspective on what’s in store for the upcoming earnings season.

Check it out now for Ristuben’s thoughts on the latest “bad headline” jobs numbers and how investors might need to shift perspective on unemployment going forward.

Share

On this week’s Ristuben Market Week in Review, Eric Ristuben, Russell’s Chief Investment Officer, Client Strategies, reviews how investors perceived the last quarter as a challenging one. But the markets, as Ristuben reminds, like to climb a “wall of worry.” The result of that climb? One of the best Septembers in many decades. Now stay tuned to see what the markets think of next week’s release of monthly employment numbers.

Share

While these results suggest that the managers see opportunities in the market, I believe managers are not expecting the same kind of surge that followed the market bottom of March 2009. The takeaway could be characterized as muted optimism, but there are probably some managers— the most optimistic ones to be sure—who may be holding out hope that a tidal change is beginning to gather momentum, one built on strong corporate earnings and a recovering economy.

According to the survey, managers are looking to business spending to drive economic growth. Nearly half of managers surveyed (49 percent) expect capital spending on equipment and construction will be the type of expenditure most likely to drive economic growth in the U.S. over the next 12 months. Eighteen percent of managers point to government spending and investment as the main driver, and 15 percent believe personal consumption will play that role.

Other findings from the Investment Manager Outlook suggest that managers’ sector preferences align with their view that over the next year capital spending will be a significant component of a slow-growth recovery. Where bullishness for the consumer discretionary sector dropped 17 percentage points from the June 2010 survey to 30 percent, traditionally pro-cyclical sectors like technology, energy, materials and processing are in favor.

Only 9 percent of managers anticipate that the economy will not experience growth over the next 12 months, which is a bit at odds with the broad speculation around a looming double-dip recession. Uncertainty led many businesses to delay expenditures in 2008 and 2009, but the managers now expect that spending to come. The question that remains is how robust the spending will be.

For more findings from the Investment Manager outlook, visit http://www.russell.com/Helping-Advisors/Markets/InvestmentManagerOutlook.asp.

Share

Advisors – facing declining revenue and a more demanding clientele – are taking a longer-term approach. Many advisors (45 percent) report they’re transitioning their clients to a fee-based planning focus. Other advisors said they are responding to clients by making short-term changes, including tactical market calls.

At Russell, we think the most successful advisors are those who focus first on goals-based planning and second on creating diversified, global investment solutions to implement their clients’ plans.

The survey also indicated that 39 percent of advisors are now selling more annuities and 26 percent are using new methods of prospecting.

In other findings, we asked financial advisors how their approach to assessing and managing client portfolio risk has changed in the past few years. Many tell us they’re being more conservative in terms of reducing risk in client portfolios. Client fear and uncertainty appear to be the primary motivation for this shift.

For more results, visit http://www.russell.com/Helping-Advisors/yourbusiness/FinancialProfessionalOutlook.asp.

Share

What a difference a month makes. On the latest Market Week in Review, Mark Eibel, Russell’s Director, Client Investment Strategies, talks about the difference between the August and September market mentalities. Eibel shows how a lack of bad news, China back-on-track and good earnings from Big Tech adds up to a happy month so far. But the countdown to midterm elections is underway.

Share

Concurrent with the debates covering individual tax policy is renewed attention to the corporate sector. With corporate profits as a percentage of GDP now standing near 40 year highs and exceptionally large amounts of cash sitting on balance sheets, analysts note that in normal economic cycles, such levels would prompt companies to spend on capital expenditures or hiring staff. Some people may believe that a lack of end demand explains firms’ reluctance to spend – rather than governmental policies as some have suggested. If uncertainty is making firms conserve cash, the exigencies for increased tax revenues may make them tempting targets. 

Against this backdrop the President’s Economic Recovery Advisory Board, a task force headed by Paul Volcker, former Federal Reserve Chairman, just published its recommendations to overhaul and simplify the tax code for all constituencies¹. The commission attempts to address the code, which has become inordinately complicated and has been distorted since its inception. Furthermore, it has not captured the millions of potential revenues. The proportion of overall tax revenues that corporations pay has been shrinking and now amounts to roughly 12% versus payroll and individual income taxes which together account for 81% of revenues. The remaining 7% is comprised of excise taxes and miscellaneous fees².

The good news is that the commission acknowledges that the U.S. corporate tax rate (at 35% plus state taxes averaging 4%) renders the 39% burden among the highest in the world. Although the effective tax rate for U.S. corporations is lower at around 29%, it remains roughly 1% higher than the world average of 28%. Among its recommendations, the commission discusses lowering the statutory rate, increasing incentives for new investment and direct expensing. Thirdly, the panel examines how to broaden the taxable base to offset any losses from applying lower tax rates.  Since many companies – such as sole proprietorships, partnerships and S Corps – “pass through” earned income to business owners, they are not subject to the double taxation whereby corporate income is taxed and then distributions (dividends or capital gains) are penalized when individuals pay taxes. Additionally, these entities comprise almost half of business tax payers so a more equitable system between corporate tax payers and other types of businesses would stimulate greater tax revenues. 

Russell anticipates that the government’s objective to reduce spending and raise revenues will continue to drive much discussion regarding how to equitably alter the tax code for corporate taxes as well as individual taxes. 

In recent years corporate taxes a percentage of GDP have shrunk from almost 6% in 1950 to a little over 2% today, thereby demonstrating the move toward non-corporate business creation. While corporate cash balances may be a tempting target, we agree with the commission that true tax reform should focus on equalization among business entities and overall revenue capture rather than a simple change in statutory rate. Until this equalization is effected, corporate taxes as a proportion of overall GDP may continue to decline. We will be paying close attention to discussions related to potential revenue raisers as well as alternative proposals focusing on consumption taxes, such as a value added tax, in order to best advise our clients.

Share

Check out this week’s Market Week in Review and find out what the troubling Anglo Irish Bank news means for Euro bank stocks and the global markets. And see why Erik Ristuben, Russell’s Chief Investment Officer, Client Strategies, thinks a double dip recession seems to be a smaller probability than ever.

Share

Who doesn’t remember the stories of the “next big thing” in the late 1990s? Those great investment opportunities all seemed headed to the moon at holiday parties in 1999, but most if not all found a decidedly lower resting spot by St. Patrick’s day. Understandably, those who bought these miracle companies are unlikely to want to discuss them after the returns have returned to less “irrationally exuberant” levels. In fact, the “next big thing” often changes industries with the times, and that same basic story seems doomed to repeat itself over and over.

Fortunately, internet losses were somewhat isolated to equity investing, and they could be recouped with smart real estate investments in the mid 2000s. After all, real estate is a valuable asset, and as we have all been told since birth, “they aren’t making any more land.” And with the exceptions of a few volcanic islands this is true. However, increasing supply and foolhardy demand spurred by loose credit are two very different things, as we found out when the mortgage markets melted down.

The previous two examples are not meant to ridicule but to remind us that we also heard friends say they had diversified portfolios of equities and fixed income and were sticking to their plans instead of chasing dreams. Some would have thought these folks to be boring at best and dim witted at worst. But even in the last decade, when calling equity markets flat seems generous, these boring investors have likely weathered market volatility better than ones who have loaded their portfolios with the latest hot stock tip. Today, these folks are called something else – smart.

Following a plan tailored to an investor’s needs with regular consultation by a trusted advisor is likely a path to success. While these plans seldom have the sizzle to discuss at your next picnic, they often lead to the best tasting steak, um, I mean course of action.

Share

If you’re a bond investor, don’t miss this week’s Market Week in Review. Erik Ristuben, Russell’s Chief Investment Officer, Client Strategies, talks about how the last few years of market volatility and inflation rates have revealed some telling patterns about bond prices that may provide vital insight on performance in the months to come.

Share

For more than a decade, the Bank of Japan has struggled to keep the country’s economy out of deflation, even though short-term interest rates have been held near zero much of the time¹.

From Russell’s perspective, the short answer to this question is that our forecast for inflation has fallen as a result of the stumble in the economy, but the projected rate of inflation remains decidedly above zero.

Our forecast for inflation in May 2010 was that the Federal Reserve would want to have inflation right at the top of its “comfort range,” which corresponds to 2 percent inflation without including food and energy prices².

Our post-stumble forecast, however, suggests that the Fed – despite its intentions – is likely to fall short and attain an inflation rate in 2011 only slightly greater than 1.5 percent. This forecast for inflation is only slightly below the latest Blue Chip consensus forecast for 2011³.

My thinking on Federal Reserve monetary policy is heavily influenced by the view that the Fed will find inflation on the low side through 2011 (but still out of deflation territory and within the comfort range of 1 to 2 percent for inflation ex-food and energy prices).

One key point about any discussion of deflation and a double-dip recession is that the Federal Reserve will push hard against a deflation scenario for several reasons. First, it is unlikely that the economy will experience a significant period of deflation unless there was a mild double-dip recession. Second, even a mild double-dip recession could be very harmful to efforts to bring the federal deficit under control.

Thus, I would expect the Federal Reserve to pull out all stops to rule out a double-dip scenario, including additional large-scale asset purchases that would further expand the Fed’s balance sheet if necessary.

Share

On this week’s Market Week in Review, Russell’s Chief Investment Officer, Client Strategies Erik Ristuben shares his review of Fed Chairman Ben Bernanke’s speech on the U.S. economic outlook.

Check it out now and see why Ristuben thinks the current soft patch shouldn’t be a surprise to anyone who has lived through the last few recessions.

Share

Furthermore, given the Blue Chip consensus forecast of very modest levels of inflation through 2011, it is now a very real question as to whether the Fed will raise the target fed funds rate in 2011. The painfully slow projected rate of decline in the unemployment rate, as indicated by the Blue Chip consensus forecast, implies that the economy will continue to have a lot of slack or unused capacity.

For this reason, we at Russell do not foresee a need for the Federal Reserve to do any “inflation fighting” in the next two years. Keep in mind that our view is based on forecasts, which represent our predictions of economic indicators, market prices and/or volume patterns using various analytical data that we monitor, and we can’t guarantee our predictions will be 100 percent accurate.

The Federal Reserve has also injected hundreds of billions of dollars in reserves to the banking system – more than necessary to achieve a near-zero short-term interest rate. In other words, the Fed has conducted quantitative easing. The Fed likely will have to undo a non-trivial portion of this quantitative easing before banks face a sufficient shortage of loanable reserves to warrant an interbank lending rate above a quarter point.

Because the Federal Reserve now pays banks interest on excess reserves, it certainly would be within the Fed’s power to raise the target fed funds rate and pay banks more interest on the approximately $1 trillion in excess reserves. Much of the reserves that banks are holding on deposit with the Fed are loan loss reserves that they will need when they write down loans¹.

At present, the Fed is paying 0.25 percent interest on these reserves, which is more than the approximately 0.16 percent the banks would receive if they invested in Treasury bills². If the Fed were to raise the target fed funds rate now, members of Congress might call such a move an unnecessary giveaway to banks, given that they are voluntarily holding reserves at a 0.25 percent interest rate.

For this reason, Russell believes the Fed is likely to wait until it has removed enough reserves from the banking system to cause sufficient tightening in short-term money markets to move the three-month Treasury bill yield well above 0.25 percent. This process will take time and it is entirely possible that the Fed will have to do more quantitative easing if the economy starts to stumble again…

*Blue Chip Financial Forecasts provide the latest in prevailing opinion about the future direction and level of U.S. interest rates. Each forecaster’s prediction is published along with the average, or consensus forecast, for each variable. Also provided are the averages of the 10 highest and 10 lowest forecasts for each variable; a median forecast to eliminate the effects of extreme forecasts on the consensus; the number of forecasts raised, lowered or left unchanged from a month ago; and a diffusion index that indicates shifts in sentiment that sometimes occur prior to changes in the consensus forecast.

Share

Check out this week’s Market Week in Review to hear Russell’s Chief Investment Officer, Client Strategies Erik Ristuben’s thoughts on the market reaction to recent unemployment claims numbers and why the economic “soft patch” in the U.S. remains a concern.

See why Erik thinks the “tug-of-war” between earnings numbers and disappointing economic data will continue, and why the global economic expansion will likely be more moderate than expected.

Share

Maybe it’s the nature of the retirement industry, or maybe it’s just a sign of the times, but I seem to have been in a lot of conversations recently where inconvenient truths have had to be faced. One example is the desire of corporations to protect their corporate earnings by assuming strong future returns on their pension assets and hence keeping as low as possible the pension cost included in the corporate earnings statement (all while staying within the constraints of current accounting standards of course). In the face of lower interest rates, this can require ever more heroic assumptions about what an individual management team can achieve (or perhaps just simple faith that the markets will turn out to have a couple of really good years).

A similar story comes when we move from defined benefit to defined contribution and the world of the 401(k). There’s a growing emphasis on the fact that 401(k)s are supposed to be providing income throughout retirement, not just a convenient tax-advantaged savings vehicle. The Department of Labor will be holding hearings on this question shortly. At the root of this question is the painful reality that a 401(k) statement that says, for example, that you have $100,000 saved might be taken as a nice piece of news, while the extra information that this is likely to be enough to produce annual income of just a few thousand dollars can make that same pot of money look pretty feeble.

Providing for retirement is expensive; there’s no way around that. There are plenty of steps that can be taken – a disciplined savings regime starting early and ramping up over time, a disciplined investment strategy, and periodic assessments of how things are going against plan. More detail on what it takes to help build a good retirement plan can be found in The Retirement Plan Solution.

In both cases, the truth may be inconvenient, but it’s better to know it and plan accordingly than to simply close your eyes and hope for the best.

Share

On this week’s Ristuben Market Week in Review, Director Multi-Strategy Solutions Erik Ogard examines the interplay of solid earnings with bad economic news. And following a very tough week in the markets, what about fears of a double-dip and deflation? Erik addresses those issues as well. Mark Soupiset hosts.

Share

Spend a few minutes watching this week’s Ristuben Market Week in Review as Russell’s Director, Client Investment Strategies Mark Eibel opens the hood on this week’s poor jobs number, the ebb and flow of earnings and economic news on the markets, and why keeping an eye on commodity prices is important. Mark Soupiset hosts.

Share

In last month’s emergency budget (June 2010), Chancellor of the Exchequer George Osborne said that most benefits, tax credits and public sector pensions that have historically been linked to Retail Price Index (RPI) would be linked to Consumer Price Index (CPI) in the future. The Public Sector Pensions Commission estimates that this change could reduce the present value of public sector pension liabilities by 10% or approximately £120bn.

More recently, Steve Webb, Member of Parliament for Thornbury & Yate and the Minister of State for Pensions, announced that this should also apply to corporate pension schemes, “The Government believes the CPI provides a more appropriate measure of pension recipients’ inflation experiences and is also consistent with the measure of inflation used by the Bank of England. We believe, therefore, it is right to use the same index in determining increases for all occupational pensions and payments made by the Pension Protection Fund and Financial Assistance Scheme“.

CPI and RPI both seek to measure changes in consumer prices. There are some differences in the constituent make up that lead to volatility between the two measures. More fundamental, however, is the methodology used to calculate the average. CPI uses a geometric average, whereas RPI uses an arithmetic average. Mathematically, a geometric average will always be lower value than an arithmetic average. On the face of it then, this change will yield a windfall reduction in the value of existing pension liabilities. However, there are some technicalities that could lead to a different outcome for some schemes depending on the wording of the trust deed.

This is the first time that a change to pensions has been applied to previously accrued benefit and the initial response to Webb’s announcement was significant. Inflation sold off 15bp over the following couple of days of his speech. Subsequently, the market has rebounded somewhat as investors have been able to assess the impact more fully.

What does this mean for the longer term? This change may yield the development of a market in CPI bonds and CPI derivatives. Initial thoughts from Britain’s Debt Management Office suggest this will not occur immediately, with preference being for a smaller number of issues (currently RPI linked).

Share

Check out this week’s Ristuben Market Week in Review to learn what Russell’s Chief Investment Officer, Client Strategies Erik Ristuben makes of the revision to the first quarter U.S. GDP numbers.

See why Erik thinks the recovery will continue to be funded by business spending instead of personal spending, and why current indicators suggest Europe won’t derail the worldwide recovery.

Share

When the money supply grows fast enough to cause nominal spending to grow faster than the real economy, the result is price inflation. Since the U.S. government began its fiscal stimulus programs in 2009 to combat the recession, it effectively increased the money supply.¹ However, overall spending has remained below trend, as measured by GDP growth. The Federal Reserve intends to keep interest rates at a 0-1/4% level for an extended period to stimulate demand, a policy that has fueled anxieties that cheap, easy money could cause runaway price inflation despite apparent price stability. The current surge in gold prices also demonstrates that some investors fear that inflation is imminent.

Demand remains weak
Currently, the U.S. economy is still emerging from recession with weak demand and an excess of goods. Price levels have increased a meager 1.7% in the first quarter (as noted in the GDP release on 6/25), down from 2% in Q4 but up from 1.3% in Q3 2009.² As the Federal Reserve noted in its June 23rd statement, the “economic recovery is proceeding and that the labor market is improving gradually.” They also affirm that “the pace of economic recovery is likely to be moderate for a time.” Regarding price pressures specifically, the Committee indicated that a low target range for the federal funds rate is warranted due to “economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” ³

What about deflation?
The Federal Reserve is sanguine about inflation given the tremendous amount of excess capacity as demonstrated by high unemployment. We note that while many of the contributors to the consumer price index (aka CPI) have been decreasing, the Fed is also committed to avoiding deflation – which is harder to combat than inflation. Declining energy and some key commodity prices, attributable to lower global demand, have caused the overall index to resume its decline. And core inflation (less food and energy) is now below 1.0, a level not seen for decades. (Click to view PDF chart)

The bond market suggests low inflation for the foreseeable future
Last week 1Q 2010 GDP was revised to 2.7% from a previously reported 3%. The prior quarters have been revised to a 5.6% and 2.25% growth rate for Q4 and Q3 2009 respectively, which is a lower bounce back than history would suggest given the severity of the recent contraction.⁴ With Eurozone worries and concerns for a slowdown in China, investors are opting for U.S. treasury investments despite historically low yields at 3% levels for the 10-year treasury. Conventional Treasury bonds and TIPS confirm a low breakeven inflation rate.⁵ While not a “Goldilocks” economy, price level measures concur that inflation is low: or not too hot and not too cold for the foreseeable future.

¹ The American Recovery and Reinvestment Act of 2009 authorized the $787 billion to stimulate the economy. As of 6/18/2010, 53% of these funds have been distributed. See www.recovery.gov.
² Bureau of Economic Analysis, statistical releases. See www.bea.gov.
³ Federal Reserve press release, 6/23/2010. See www.federalreserve.gov.
⁴ Bureau of Economic Analysis statistical release dated 6/25/2010.
⁵ An analysis of the breakeven rate (the difference between nominal treasury securities and TIPS yields) demonstrates that over time TIPS breakeven inflation rates are a useful proxy for inflation expectations. See “Tips from TIPS: the informational content of Treasury Inflation-Protected Security prices” by Stefania D’Amico, Don H. Kim, and Min Wei, February 27, 2008 published at http://www.federalreserve.gov/pubs/feds/2008/200805pap.pdf.

Share

Check out this week’s Ristuben Market Week in Review to learn why Russell’s Chief Investment Officer, Client Strategies, says the headlines are skewing negative but earnings and the markets seem not to be paying attention. Also learn what Erik has to say about last week’s European bank stress tests and why they may not really prove much. And don’t take your eyes of the markets this week, as there are a number of very important indicators coming out over the next few days.

Share

The difference between a casual fan of cycling and, as the Italians say “tifosi” – the super fans who are deeply passionate about their teams – is usually their understanding of one of the most critical factors in racing success: teamwork. Coaches, mechanics, and cyclists’ families form an important support team. And so does the peloton.

The peloton, a pack of cyclists from different teams, are a key element of a winner’s strategy. While it may look like the rider at the front of the pack is working alone, it’s the support of the team that put the leader in position. You’ll often see a pack of riders break off and try to win a specific stage, however, everyone usually stays in one group.

Every support rider or “domestique” has a specific role to achieve the overall team goal. Some riders are tasked with setting a hard pace at the front of the peloton while others return to the team car to fetch food and water. Others are charged with guiding the leader into the high mountains, setting a pace for the team leader and blocking the wind. Still others might ride a blistering tempo, chasing a breakaway so the team leader can ride to victory.

It can be tempting for investors and cyclists to try to break free of a consistent, thoughtful strategy when activity around them seems volatile. Steady, consistent execution on a strategy likely wins out over reactive behaviors long-term. Six riders in the history of the Tour have won overall without winning a single stage. And the opposite can be true. Even in investing, you can win a short-term gain by timing the markets, but that wouldn’t translate to overall financial success.

Teams play strategic roles in investing too. A complete financial plan should address more than just investment planning. Work with your advisor to identify other experts you might need on your team, including accountants, attorneys, and insurance professionals who, among other things, can offer advice about tax and estate issues.

In the Tour, teams consist of a variety of specialists who take on roles, including climber or sprinter, or even who lines up first to lead a sprint. Great teamwork drives success in the Tour de France. In cycling or investing, it is exceedingly difficult to win without it. Viva la Tour!

Share

Beyond the changes proposed to the financial system at large, the legislation also introduces changes affecting many American consumers and investors. While I won’t attempt to encapsulate all the elements of the bill, there are a few immediate highlights that stand out in terms of impact and possible unintended consequences.

One of the highlights of the Act is that the “too big to fail” bailouts will effectively be history. Regulators can authorize firm closures if they are judged as overly risky and taxpayers are not obligated to “save” a financial institution. Under the Act, a Financial Stability Oversight Council comprised of ten regulators (from the Federal Reserve, Treasury and the SEC) will work to identify system-wide problems before they become catastrophic. A new Federal Insurance Office will also provide industry oversight historically limited to the states.

The legislation introduces new costs to banks, dictating greater reserves and less debt on the banks’ books. Banks have reacted by hoarding cash and lending less. Prior to the Lehman and Bear Stearns failures, banks could lend up to thirty times their amount of capital – that ratio is now below ten.

Transactions of derivatives, or financial instruments that derive value from other financial instruments, will also be moved away from inter-bank agreements to an independent exchange. Derivatives trading related to the volatile agricultural and energy commodities and other complex securities must be transferred from the bank to a holding company.

The Act’s Volcker Rule is also designed to limit banks’ ability to make speculative investments for their own profit rather than on behalf of their customers. The Volcker Rule will define the extent that firms can trade their own funds (e.g., proprietary trading which can lead to conflicts of interest).

Several intended benefits to consumers will also be introduced, including the newly created Consumer Financial Protection Bureau which will ensure that Americans receive clear and accurate information about mortgages and credit cards. In addition, consumers can pursue education through the new Office of Financial Literacy. The Federal Reserve is also committed to setting reasonable debit card fees within nine months after the bill is passed.

In addressing mortgage reform, lenders will be penalized for irresponsible lending and prohibited from charging pre-payment penalties. Banks face the loss of lucrative fees related to riskier products such as subprime mortgages, and borrowers will be able to receive housing counseling through the Department of Housing and Urban Development (HUD).

Unintended consequences?
In attempting to introduce greater stability and clarity to the financial system, the Dodd-Frank legislation increases the costs of doing business for financial institutions. While providing a variety of arguable benefits, some might assume that higher costs will be passed on to clients and customers and potentially produce some unintended consequences:

• Bank investors could make less – Banks stand to become less profitable due to higher reserve requirements and risky activity restrictions (“financial innovation”), which could impact some investors’ returns.
• Consumers may have less access to credit and mortgages – Numerous safeguards are designed to protect consumers from predatory practices. However, some consumers may now have limited access to funds due to higher down payment mandates and other strict criteria.
• Hedgers could pass on higher fees – Farmers, airlines and industries often use derivatives contracts to lower risk by locking in advance prices for commodities such as corn, beef, fuel and metals². An increase in transaction costs or making it harder to create these hedges would likely drive up prices.
• Regulation could become stagnant – Regulators could become less proactive or future legislation may be impeded if consensus regards the Dodd-Frank Act as the final answer to fixing financial institutions.

While the ramifications of the Dodd-Frank Act are still yet to be seen, many consumers and investors will feel the impact of greater transparency in financial services and increased consumer protection.

Share

Tour de France cyclists can’t sustain a winning pace without properly fueling their bodies. Along with the art and science of bike technology, cyclists must fine-tune their eating strategies to sustain energy levels needed to compete in six-hour (or longer) races. Former racer and Armstrong coach Chris Carmichael reports that riders eat up to 10,000 calories a day during the most grueling stages of the race.

This concept of contribution to fuel a strategy is familiar to investors who are saving to meet specific financial goals. It’s difficult to meet your spending goals without adequate financial contributions. In order to accumulate assets to draw on in later years, we must make regular contributions to our plans. This concept is often expressed in homespun clichés like “it’s not what you make but what you keep,” or “pay yourself first.” Despite sounding like maxims from my rural Texas upbringing, they’re worth considering.

The money you save for retirement when you are in your 20s simply has the power of time on its side. As my wonderful 84-year-old grandmother reminds me: “There are only two good days to save money and plant trees – 30 years ago and today.” To see growth at any stage of the race, you must contribute.

Learn more lessons from the Tour de France in “Stage 5 – Teams set the pace”

Share

Check out this week’s Ristuben Market Week in Review to learn why Russell’s Chief Investment Officer, Client Strategies, thinks recent intraday trading trends seem to indicate a positive mood in the market. See what Erik believes about the new regulatory regulations that just passed the U.S. Senate. And find out why the next few weeks are all about earnings, earnings, earnings.

Share

Any fan of cycling is familiar with the racing adage, “You only have so many matches to burn.” This is a reference to the finite number of hard efforts that a racer can physically make. The smartest racers know exactly when to use these efforts to gain the most time on their rivals. They also know not to waste energy if the payoff is limited or unlikely. In fact, the smartest (and usually successful) rider will always try to save a match or two to cover any unforeseen problems or challenges.

Successful investing mirrors this concept almost perfectly. The best investors always consider an investment’s risk along with its potential return. Stated simply, these investors seek compensation for taking risk. This simple, yet often overlooked, concept is called risk budgeting. Investors determine how much risk they can afford and set expectations for corresponding returns. Additionally, if goals can be accomplished with less return, investors would likely decrease their level of risk. This concept doesn’t mean that investing is pain free.

In cycling, the most successful efforts, or burnt matches if you will, often come when it feels the absolute worst. When a rider is struggling over a mountain pass, pushed to the limit by the race, it becomes a physically and emotionally draining experience to try to break free or even stay with the race leaders. However, it’s at these moments the very best riders rise to the top. This is exactly the dilemma investors face when markets are volatile. Historically, those with an appropriate, well-planned strategy tend to fare better in volatile times.

Learn more lessons from the Tour de France in “Stage 4 – Fuel for the race: Contributions count in cycling and investing”

Share

With apologies to my fellow Texan, Lance Armstrong, sometimes it is about the bike – or in the case of investing – asset allocation. You may be familiar with the story of Armstrong and his return from cancer to Tour de France dominance. In fact, he authored (along with Sally Jenkins) a great book chronicling this story titled “It’s Not About the Bike.”

While the essence of the book was that the bike didn’t make the rider (as all pros have access to similar technology), you can’t discount the power of the bike. For example, just as a tour rider would never take a bike meant for flat, fast time trials through the Alps, an investor shouldn’t take someone else’s asset allocation as their own without thoughtful consideration.

Asset allocation is one way an investor can tailor the risk and return options available in the market to fit his or her desire for return and tolerance for risk. This isn’t to say that there is one magical asset allocation. However, the allocation of equities vs. bonds largely determines the likelihood you’ll achieve your goals. This choice isn’t a one-time decision but investors must periodically evaluate it against changing risk tolerances and liquidity constraints and more importantly, it shouldn’t be subject to headline noise.

As cyclists prepare for the tour, they study the route, build the team and train around it. The route dictates the plan and the training, which is all about the plan and the eventual goal. Like investing, nothing is flawless. Unexpected crashes during the race drive unanticipated changes to strategy, requiring the team to regroup.

While a particular asset allocation can’t protect you against all risks in a down market, a financial advisor can help tailor an asset allocation that best fits an investor’s goals and objectives. While an individual may be able to determine the best allocation for their needs, often the advice of an advisor can mean the difference between a good fit and a great fit. And as any cyclist knows – if the bike is a great fit, you’ll be a better rider.

Learn more lessons from the Tour de France in “Stage 3 – Burning matches and risk budgets”

Share

To achieve winning results, investors and cyclists must live these five elements – patience, allocation of resources, risk budgeting, fueling a strategy, and team work.

Stage 1 – Patience is a virtue – in the race and investing

The Tour de France is a serious endurance contest comprising 21 races (stages), but it’s a small thing compared to the very long time frame that most investors face as they invest to meet their goals, whether it’s saving for a child’s education, retirement or other life goals. In fact, with a time horizon of years and often decades, investors are best served by focusing on the long-term compounding potential of their portfolios.

With time, you may need to reconsider risk preferences and asset allocations as you experience life changes, but know that the day-to-day noise that masquerades as news is usually irrelevant as you manage your finances. Investors can make the most effective impact on their portfolios by taking a longer-term view of the markets and staying on plan.

If we can learn anything from the length of the Tour de France, it’s just to stay in the race as long as possible and focus on the long-term goal. It’s easy to get caught up trying to guess the market’s future trajectory or which stock or asset class is hot. Think about the overall race, not each stage. It’s what you do consistently, over time that propels you to your ultimate goal.

Learn more lessons from the Tour de France in “Stage 2 – Investing and the Tour de France: It (sort of) is about the bike, er rather asset allocation”

Share

With so much market volatility over the past few years, many investors are taking their money out of the stock market to find something that may feel safer like cash or bonds. Investors who have decided to stay in the markets may be questioning whether their efforts at picking stocks or mutual funds are adding value. Hot-stock stories are a hit at cocktail parties, but when you take an honest look at how your portfolio has been doing lately, did you really beat the market?

To truly understand the performance of your portfolio, we believe you need to do two things:

1. Compare your portfolio’s performance against a market measure or benchmark that best reflects the risk of the types of investment you make. If you like to buy bonds, consider some measure of the fixed-income market. If you tend to buy stock in small companies, you should use a small-company index. For most U.S. investors, a broad measure of the U.S. stock market is most appropriate. If you are buying stock in global companies then perhaps a global index is best.
2. Evaluate your performance over a meaningful time period, using the same time frame for your portfolio and the market benchmark that you chose. Note that the gain/loss amount shown on many brokerage statements isn’t usually appropriate as a performance measure since it only reflects the time period from which you bought the stock, and can be different for each holding in your portfolio.

Although you should consult with your financial professional or tax advisor for specific advice, as an example, assume you had $100 to invest at the beginning of this year and you picked stocks yourself. If you focus your efforts on U.S. companies of any size, we believe the appropriate benchmark is the Russell 3000® Index, which represents over 98% of the companies available for investing in the U.S. market.

If at the end of April you had $110, you would have a 10% return. Did you beat the market? To answer the question you would need to look at the Russell 3000 Index performance over the same period. In this case, the Russell 3000 had an 8% return so you did indeed beat the market. But now imagine that you really focused on picking stocks of riskier smaller companies. In this situation, a better benchmark is the Russell 2000® Index, which measures the performance of the smallest 2000 stocks in the Russell 3000. Through April, the Russell 2000 Index was up a little over 15%, which means that your portfolio didn’t beat the market. You may have been better off buying a product that mirrored the return of the index over this period.

As long as you choose to stay invested in the market, this process never ends; with the availability of index funds that are designed to give you the market return, you must constantly evaluate the benefit of picking stocks or funds yourself.

Share

Despite an economy beset by massive financial problems, the United States dollar has been seen as a safe haven in times of global turmoil. Since the start of 2010 (through June 10), the dollar has risen almost 12 percent against six major currencies. That increase, while significant, is minor compared to the long-running decline of the dollar that began in early 2002. From that time through the end of 2009, the dollar declined over 35 percent against those same six currencies.

That decline provided a significant boost to the return from foreign assets held by U.S. investors, as the value of those assets rose as the U.S. dollar fell. It was advantageous for U.S. investors to be fully exposed to the dollar’s weakness whereas many international investors holding significant amounts of U.S. assets hedged their portfolios against a weak U.S. currency by selling dollars and buying their domestic currency.

But what now for the dollar? Is this upturn sustainable, and will the greenback embark on a period of significant strength? If so, what will the impact be on the return of foreign assets for U.S. investors? Global economic turbulence hampers a clear call on currencies, but Russell researchers think dollar strength is more likely than dollar weakness.

In a recent Russell research article sent to institutional investors (June 2010), Head, Currency Implementation Ian Toner, Director, Forecasting Steven Fox, and Head Economist, North America Michael Dueker discuss the outlook for various currencies. The authors remark that despite a statistical model output that suggests the euro is not undervalued, the current position of the euro and short-term forecasts call for substantial depreciation in the euro toward dollar parity.

Other important currencies face weighty problems. High deficit and debt levels in the United Kingdom will likely keep one of the world’s most important currencies weak compared to the U.S. dollar. In Japan, policy makers seem likely to turn to yen depreciation to help solve that nation’s economic woes. China and other East Asian countries that peg their currencies to the U.S. dollar are effectively importing looser monetary policy from the United States than they need to keep inflation off their radars.

The researchers note that the U.S. economy has its own obstacles that may depress the dollar, including continued low interest rates, deleveraging and the required transition of a consumption economy to one that’s more export dependent. Weighing these matters, and commenting that currencies are likely to remain volatile compared to historical levels, the authors opine that U.S. dollar weakness is unlikely.

If the dollar strengthens, U.S.-based investors could experience declines in returns from foreign assets. To counter lower returns caused by currency movements, U.S. investors could hedge that risk by selling foreign currencies and buying dollars in the forward market.

Russell’s long-standing advice regarding a strategic hedge ratio (a long-run choice where one does not consider short-run opportunities to forecast the direction of an exchange rate) has supported hedging 50 percent of an institutional investor’s currency exposure. Nevertheless, numerous dollar-based institutional investors have remained unhedged, despite the fact that they may have increased their holdings of foreign assets.

Now may be a good time for such investors to re-evaluate their choice not to hedge their currency exposure because a U.S. investor who is unhedged is perhaps unintentionally betting on dollar weakness at a time when dollar strength seems more likely. Keep in mind that these views may change at any time without notice based on market conditions.

Share

About a quarter of the advisors reported that the reason their clients face a retirement shortfall is that they don’t save enough, and 22% of advisors said their clients simply don’t have enough money to save. Twenty percent of respondents cited “overall market risk” and 17% cited “clients holding portfolios that are too conservative” for their retirement goals as reasons for clients’ shortfall.

Given the level of responsibility individuals have for their own retirement income, do you agree that this is a call to action for our industry as a whole? With so many individuals underinvested, we believe advisors now need to have difficult conversations with their clients about whether they’ll increase the amount they’re saving, are willing to work longer, or want to invest more aggressively.

The discussion has shifted away from how investors feel about risk. It’s “what’s the minimum amount of risk you have to take.” Because of the underfunded nature of most investors’ portfolios, they should consider taking on some market risk to earn a return if there’s any hope of closing that gap.

The key is to establish goals and construct a goals-oriented portfolio. Our industry in general is moving toward goals-based outcomes. However, many advisors are ill-equipped to steer their clients in that direction. The reason: a process engineering problem. We need to find a methodology to engage efficiently and develop tools to help them with this new approach.

For more results, visit http://www.russell.com/Helping-Advisors/yourbusiness/FinancialProfessionalOutlook.asp.

Share

The prop trading prohibition is known by its primary advocate, former Fed Chairman Paul Volcker. At this writing the details of the reform bill are not final, but The New York Times (June 15, 2010) reported that financial industry lobbyists have all but conceded the passage of the rule and have moved on to other topics, such as derivatives.

So what are the implications?

The Volcker Rule can be viewed as a positive move away from what is known as the problem of public risks, private profits. Akin to moral hazard, the problem describes conditions where individuals who stand to profit from risk-taking do not bear the costs when things go wrong. Such conditions motivate higher levels of risk taking than might otherwise be taken. The rule addresses the concern that adverse incentives are created when cheap capital from federally insured bank deposits can be used to fund a bank’s proprietary risk positions.

Congressional support for the Volcker Rule is surprising because the preponderance of official action since 2008 has been to transfer failed risk positions away from private books and onto public balance sheets. In 2007, few would have believed that the U.S. government would become outright owners of Fannie Mae and Freddie Mac, become a controlling interest shareholder in hundreds of banks and a holder of hundreds of billions of privately created debt instruments.¹ The Volcker Rule stands apart for addressing a real, structural problem of misaligned incentives, and as going against the tide of past responses to the ongoing financial crisis.

Having said that, there may be too much money in prop trading for most banks in question to drop it altogether. A likely industry outcome will be a splintering of corporate structures, with proprietary trading structures re-emerging as separate legal entities, perhaps as prime brokers or independent hedge funds. More broker dealers, who often have proprietary trading operations, may open up to the agency model of trading.

So far, much of the focus appears to be on equities trading. What is not clear will be the ramifications for asset classes which are traded primarily on principal markets, such as fixed income or currency. Could the agency model become more accepted in fixed income and currency? It will be interesting to see how this plays out.

Institutional investors, who may indirectly trade with proprietary trade flow as a matter of course, may see little difference in market functionality from the rule. Taxpayers, who are looking at already tremendous debt levels, could see at least one area of potential liabilities reduced.

Share

The Russell Investments Global Survey of Alternative Investing, seeks to answer many of these questions.

To provide a little context, you might look at the growth of alternative investing as being divided into three phases:

1. The initial era of acceptance among institutional investors, culminating in 2007;
2. The global financial crisis of 2008 and early 2009, which heavily impacted alternatives; and
3. The recovery and evaluation period now underway, which we believe is leading to a re-commitment to alternatives for the future.

In the new Russell survey, we offer a comprehensive evaluation of trends and themes that will emerge in this third phase and beyond.

The overarching findings indicate that alternative investments have survived the storm and are on the way to recovery. Furthermore, institutional investors around the globe have become increasingly aware of the role alternatives play in portfolio diversification and risk management.

Given this mindset, they remain committed to these investments, and survey results forecast increased allocations to alternatives. In fact, institutional investors responding to the survey expect an increase of over a third (from 14 percent to 19 percent) in their allocation to alternatives over the next two to three years.

Not surprisingly, the survey also reveals a rising tide of risk-consciousness, as the financial crisis has raised the bar for alternative providers in areas such as liquidity and transparency. To illustrate this takeaway more concretely, a striking 84 percent of respondents have made or plan to make changes to their risk management approach for alternatives, and nearly two-thirds are increasing the sophistication of their internal decision-making and governance processes.

At the same time, there is an increasing awareness that alternatives are an integral part of a defensive portfolio. The number one attribute that survey respondents indicated as a driver for increasing allocations to alternatives is “reducing volatility.”

Ultimately, a major variable in shaping alternative investment commitments and strategies will be the future direction of global economies and financial markets. Still, the results from our new survey lead us to believe that if the current global recovery were to falter at some point, alternatives have gained enough “critical mass” to maintain and gain momentum.

Share

In contrast, Ireland’s record of strong GDP growth and history of previous fiscal turnarounds means that investors have been far more lenient with respect to lending. Japan’s position looks the worst of all, but it has a current account surplus, meaning it can fund its fiscal deficit with domestic savings.

It is hard to make a confident prediction as to how the European financial crisis will play out. The best case scenario is that the bailout package successfully calms fears about a near-term Greek default, while Portugal and Spain make at least credible commitments towards deficit reduction and economic restructuring. This would need to be accompanied by a sustained euro-area economic recovery to generate confidence that member countries won’t leave the single currency. The worst case scenario is that the pain of deficit reduction becomes too great, triggering a default and an exit from the euro.

Thankfully, the European Central Bank seems to have learned the contagion risk lesson of the Lehman collapse and has moved quickly to assure bond investors that it stands as the last resort government debt buyer. This may alleviate the fear of a liquidity shortage and should prevent a full-scale, Lehman-type crisis.

Unfortunately, the issues surrounding potential euro-area defaults and disintegration of the euro are not likely to disappear anytime soon and will be a continuing source of volatility for global investment markets. The positives are that this episode is occurring against the backdrop of generally improving euro-area economic indicators, and euro devaluation will help export competitiveness. Better news on the euro-area growth outlook could go some way towards calming default fears.

From an investment strategy standpoint, the crisis may open up an attractive entry point for increased allocation to risk assets such as equities. Risk premiums (the difference in return between a low risk asset such as U.S. government bonds and a more risky asset) might rise for a while, but cash rates most likely won’t and this will anchor the interest rates central banks charge depository institutions to borrow.

Overall, the crisis seems unlikely to seriously derail the global recovery in corporate profits. It may make sense to buy when fear and uncertainty are as high as they can get…

Note: These views are subject to change at any time based upon market or other conditions and are current as of the date of this entry. Forecasting is inherently uncertain and can be incorrect.

Share

A default (or when an issuer is unable to make the income and principal payments) on any rung of the ladder may leave an investor with limited replacement options and thus, a portfolio management headache. A default reduces coupon income in all years earlier than the maturity date of the defaulted bond and painfully reduces the cash flow scheduled for the year the defaulted bond was to mature.

If the ladder portfolio is the investor’s only liquid asset, he or she has to choose among different options including living with the damage as is, trimming other rungs on the ladder to smooth the decline in income, or liquidating the longest bonds in the portfolio.

The last option can cannibalize the last rung on the ladder to replace the defaulted bond (repair the broken rung). Restoration of the perfectly equal yearly cash flows requires bonds at every maturity to be re-weighted – inevitably leading to transaction costs and taxable events.

So with respect to municipal bonds, what’s the word to the wise? We believe laddering is harder than it looks, especially with odd lots, on both the buys and the sells. And, laddering only provides minimal credit risk diversification due to the limited number of bonds held. Plus, municipal pricing is notoriously sensitive to credit rating changes. If you invest in bond ladders instead of other vehicles, you may want to check the insurance ratings of the underlying issues. Other things you want to be mindful of include interest rate risk, inflation risk, call risk, prepayment risk and reinvestment risk.

Just like the lessons we learned in the cash markets last year about diversification, credit and liquidity, there could be a lot more risk than meets the eye…and you don’t want find that out too late. As always, consult with advisors and tax professionals as you invest.

Share

Check out this week’s Ristuben Market Week in Review to learn why Russell’s Chief Investment Officer, Client Strategies Erik Ristuben believes volatility is likely to start leveling off in July. Erik also explores whether policy changes in Europe will have an impact any time soon.

Share

The package is meant to meet the borrowing needs of these five countries’ governments for the next two to three years in the event that private debt markets charge interest rates that are “too high.” With a lid on interest expenses, these countries should have a better chance of reining in their fiscal deficits in the next two years.

One perhaps unintended consequence of the rescue package is that it effectively postpones the “day of reckoning” for Eurozone countries such as Greece, and thus the markets may face two years of uncertainty. The possible outcomes are numerous, but there are four that seem most likely:

• Greece defaults on, or involuntarily reschedules, its government debt but stays in the monetary union.
• Greece’s government austerity program works and generates a new round of lending in private debt markets in two years, such that default is averted.
• Greece exits the monetary union and devalues its currency, its sovereign debt, and private bank deposits and debt contracts as well.
• Greece exits the monetary union and devalues its currency but does not forcibly devalue bank deposits.

In short, Greece looks a lot like Argentina circa 1998, when the country had a hard, supposedly irrevocable peg to the U.S. dollar. In Argentina’s case, they aimed for the second outcome above but ended up with the third after putting their economy through a grinding, multi-year, austerity-laden recession.

With a precedent like this, it is easy to see why investors are wary of the euro at this juncture. Not only do we face two years of uncertainty regarding the future of euro-denominated government debt, but also the composition of the monetary union itself. It might turn out that the common monetary policy simply does not deliver sufficient nominal GDP growth to allow the peripheral countries to grow out of recession and government budget deficits.

In addition, investors have to weigh which outcome would be best for core Eurozone countries such as Germany and France. Would France and Germany export more to the peripheral countries if those nations remained members? Or if they exited, devalued their currencies but re-invigorated their economies?

Across Europe, the rescue package casts a pall of uncertainty that is virtually guaranteed not to be resolved soon. Given how markets hate uncertainty, it seems the euro is apt to continue a downward course toward parity with the U.S. dollar.

Share

One meeting attendee recently encountered an influential lawmaker who was in a state of high enthusiasm. Why the excitement? With health care reform out of the way and “fixed,” legislators could now devote their attention to retirement plans. The retirement contingent in audible proximity could barely suppress their groans, “Oh great, now it’s our turn.”

401(k) plans have been described as the new retirement superpower*, and that status brings with it a world of responsibility and high expectations. To the extent that coverage, savings rates, investment quality and so on are falling short of those expectations, we should expect increased engagement from Capitol Hill. For years, 401(k)s flew under the radar, with attention primarily focused on defined benefit plans. With the changing of the retirement guard, that won’t be the case going forward.

As you’d expect, the main focus of the meeting was health care reform, and what it means in practice. They say that the law and sausages are two things you do not want to see being made. I believe it. For the unnamed lawmaker and others at the top of the legislative pyramid, we are already in the aftermath of health care reform. For those who must implement it, it’s just the beginning.

* See The Retirement Plan Solution: The Reinvention of Defined Contribution, by Don Ezra, Bob Collie and Matt Smith, published by John Wiley & Sons (2009).

Share

Case in point: In the midst of downward spikes in the last few weeks (May 2010), corporate earnings (both actual and expected) have been steady to strong. The markets have dropped mainly on concerns of European sovereign debt and financial regulation.* While I don’t dismiss the role the credit markets play it does seem that some investors’ concerns about one asset class spur them to punish another.

In fact, as credit concerns travel the media circuit, many investors are rethinking their investment strategies. In effect, they no longer want to buy (or in some cases hold) assets that have declined in price. The irony here is that despite growth in corporate earnings, investors may perceive some assets as less desirable because they cost less. While not all stocks are a “good buy” just because they’re priced low, it’s irrational to not buy because the asset is cheap. It’s when investors buy low that they may have the best chance to reap the upside in the event that equity prices rise.

Of course, while impossible to know for sure if assets are cheap or dear at any point in time, investors should take solace in knowing that in general, sticking with their plan when others are running for the hills may give them a better-than average-chance of reaching their goals. Check with your financial professional or tax advisor for specific advice.

*A quick primer on market valuations offers a glimpse into this behavior. Most, if not all, finance coursework includes an examination of the price to earnings (or P/E) ratio. This simple thumbnail sketch of analysis is meant to give us an insight on the relative valuation of an asset. For example, if the Russell 1000® Index has a price of 1000 and earnings of $100 it’s P/E ratio would be expressed as 1000/100 = 10. If the P/E ratio were to rise to 20 (2000/100) we might be tempted to view the market as expensive or if it fell to 5 we might believe it to be “cheap.”

Share

Are investors nearing retirement looking anew at long-term financial security goals now that the market rebound is more than a year old?

In our quarterly survey of financial advisors across the nation, advisors reported that their clients within five years of intended retirement now display a slightly different view on risk tolerance since the March 9, 2009 market rebound began. Half of advisors said their clients wish to be slightly less aggressive, while another 27% wish to be significantly less aggressive. Only 14% of advisors said their near-retirement clients had not changed their risk appetites, while less than nine percent said their clients wanted to be slightly – or even significantly – more aggressive.

Conducted earlier this year, our Financial Professionals Outlook questioned 900 financial advisors nationwide from about 260 national, regional, and independent advisory firms to gain insight into how they’re facing the challenges of the markets and their practices, including opinions on their clients, products and their plans to allocate among different asset classes. When asked how they would shift allocations among asset classes in the next 12 months, advisors said they planned to increase their exposure to international markets, with 53% and 49% of respondents planning to increase their allocation to the riskier asset classes of emerging market equities and non-U.S. (developed market) equities, respectively.

U.S. Treasuries (47%), high yield bonds (33%) and cash (33%) lead the list of asset classes to which advisors will decrease allocations over the next year. Advisors are now focused on charting a deliberate course to help their clients recover from losses many experienced due to the financial crisis of 2008, according to the survey.

For more results, visit http://www.russell.com/Helping-Advisors/yourbusiness/FinancialProfessionalOutlook.asp.

Share

Broker-dealers provide liquidity to markets by acting in one of two roles. First, acting as agents and facilitating the matching of buyer and seller, in which case they act as brokers. The second is when they buy or sell for themselves and hold a proprietary “book” or investment portfolio, in which case they act as dealers. At times and depending upon the portfolio of trades, broker-dealers may fulfill both roles simultaneously. Given the inherent conflict of interest when acting as a dealer by buying or selling securities from clients for their own books, regulators hold a broker-dealer to a different standard than investment advisors.

Investment advisors on the other hand are engaged as fiduciaries, which means they are in a position of trust and required to put the client’s interests before their own. The fiduciary standard makes problematic the imputing of spreads on client trades against a proprietary book. It also poses problems for the placement of principal bids or offers on client trades when information is asymmetrical, that is, when the dealer knows more than the client about that name or market. Hence the need for clarity of role when client relationships are contractually defined.

Traditionally the conflict inherent in broker-dealer relationships is accepted by clients and regulators, who trust competition, monitoring and the broker-dealer’s interest in maintaining long-term relationships to keep pricing in line with the market. Broker-dealers often take on risk by holding inventories of securities and thus their compensation is generally seen as warranted. In return, price discovery is facilitated and the markets can be more liquid. Further, many broker-dealers manage the conflict by acting purely as agents (viz. brokers), charging an explicit commission and facilitating the trades with third parties in the appropriate market venues.

The proposed Finance Reform Bill amendment is attempting to introduce the full fiduciary standards of an investment advisor to the broker-dealer relationship. If passed, the bill’s amendment would be sure to trigger a re-org on Wall Street.

Share

Bailing out at the first hint of trouble likely defeats investment progress. In fact, investment policy statements are written in cooler times to remind investors, though perhaps more elegantly, not to engage in this behavior.

However, days like May 6 can tempt even the most stalwart investors (and their advisors) to question if another market downturn is beginning. In fact, that particular day a great deal of noise in the market could have jangled some nerves even before the “trading glitch” in the last hour or so of trading. Concerns about the U.S. economy, European debt (mainly the situation with Portugal, Italy, Ireland, Greece, and Spain), and of course the lingering unsteadiness of the last few years, formed a woodpile waiting for a spark. The trading that occurred in the last hour of the day may have proved just such a spark for many.

As the news channels screamed rumors of “fat finger trades,” terrorism, program trading, and computer glitches as causes of this market retreat, many were tempted to “avoid the next 2008″ and bail. Of course, while market fluctuations are a given, we don’t think the next market crash started on May 6.

While interesting to talk about, the events of May 6 may not have a meaningful impact on long-term market returns. However, what about the investors who heard the noise, panicked, and “bailed out” of the market? These investors now face a dilemma of having likely locked in losses and now must find an entry point back into the market. This task is every bit as difficult today (and maybe more so) as the market bottom on March 9, 2009. Giving in to panic and getting out of the market is the easy part of the market timing trade. Getting back in can be difficult and scary. I suspect it will always be this way.

Many financial advisors likely had to counsel their clients to stay the course and hold firm to their convictions. The value of such advice is seldom reflected short term such as in quarterly performance reports, but it is paramount because those advisors create an opportunity for their clients to experience the long-term impact of staying invested. This advice is executed in minutes, but it can reap benefits for years to come.

Share

Case in point: the Restoring American Financial Stability Act. With a name like that, it has to be a good idea (right?). Well, round about page 656 of the 1,566 pages of this proposed law is the following clause:

“Pension plans; endowments; retirement plans – A swap dealer that provides advice regarding, or offers to enter into, or enters into a swap with a pension plan, endowment or retirement plan shall have a fiduciary duty to the pension plan, endowment, or retirement plan, as appropriate.”

Now, you might imagine this would be good news for the pension plans, endowments and retirement plans in question. After all, the fiduciary standard of care is the highest standard of care offered by the law. Gather some lawyers together over a nice bottle of wine and talk about fiduciary status, and you are likely to hear a quotation from Supreme Court Justice Benjamin Cardozo, circa 1928:

“Many forms of conduct permissible in a workaday world for those acting at arm’s length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.” [Meinhard v Salmon]

A punctilio, in case you are not aware, is a fine point of etiquette, or meticulous observation of formalities. Fiduciary status is a weighty burden, that is more than just a specific code that defines actions. So you get the picture: fiduciary status is a big deal in the law. It is, indeed, such a high hurdle that it cannot be applied to most business interactions, as Cardozo made clear. And, most particularly, it does not sit naturally with acting as a counterparty to a deal. Actually, let me word that more strongly: it is patently ridiculous to attempt to apply this very high standard of care to the interaction between a buyer and a seller. Because whatever other duty each counterparty owes to the other, and there are several, they are irredeemably in conflict over the question of price. Counterparty status and fiduciary status just don’t mix.

ERISA makes this explicit:

“A fiduciary with respect to a plan shall not deal with the assets of the plan in his own interest or for his own account.” (ERISA Section 406(b)(1))

So decades of fiduciary law precedent and an explicit statement in ERISA make it clear that you cannot be a counterparty to a transaction if you are a fiduciary¹. Yet the new legislation, too hastily drafted, would require that counterparties to swap transactions become fiduciaries. This would create a Catch-22 situation in which you can only enter into a swap transaction if you are a fiduciary, but if you’re a fiduciary you cannot enter into a swap transaction.²

The result of the law then would not be to offer greater protection to pension plans and others participating in the swap market. Rather it would be to close that market down. In other words, this is a well-intentioned proposal that has been drafted too hastily, and has been too quick to take a good concept – the fiduciary requirement – and misapply it where it does not fit.

Our lawmakers are in a difficult position. The existing regulatory mechanisms were not effective in the financial crisis and its aftermath. The political pressure to act is enormous. But in this case, they’ve been too fast on the draw.

¹ I should add the caveat here that there is a significant volume of case law, exemptions and advisory opinions around ERISA that make the true picture somewhat more murky than I have painted it here, although I believe the principle is solid. This opinion should not however be taken as a definitive interpretation of ERISA’s application to any specific situations, and is certainly not to be taken as legal advice.

² Heller, Joseph (1961). Catch-22. Simon & Schuster. “There was only one catch and that was Catch-22, which specified that a concern for one’s safety in the face of dangers that were real and immediate was the process of a rational mind. Orr was crazy and could be grounded. All he had to do was ask; and as soon as he did, he would no longer be crazy and would have to fly more missions.”

Share

Sustainable growth isn’t consistent with high magnitude booms and busts, as we’ve experienced. We need to engineer in stability even at the expense of some efficiency.

Maybe a consumer protection entity will be the answer to monitor and evaluate innovative new products. Markets can still be, on average, the best way to allocate resources, so we may need prudent regulation and some loss of efficiency so the markets can work more effectively.

The highest growth rate and biggest increase in standard of living in the U.S. (and maybe world) history was in 1947-1973 – a time when government regulation and modulation of the economy was at its highest level.

Like it or loathe it, we need to get used to the idea of more government intervention in the markets (certainly since the 1980s) than we’ve been accustomed to.

Share

Diversification: yes, that’s important. A well-designed, dynamic asset allocation strategy (glide path): also critical. Best-of-breed investment managers: another good idea.

Still, at the end of the day, what really matters is how much a defined contribution account will provide per month during retirement–something that is certainly very much impacted by the items mentioned above.

The proposed “Lifetime Income Disclosure Act” (S. 2832) introduced to the U.S. Senate in December could require plan sponsors to make sure that plan participant statements report just that—account values not only in terms of total dollar figures, but in terms of projected income replacement during retirement.

The benefits of a retirement income-focused statement can be many. Equipped with these projections, plan participants may make better decisions about saving, changing their asset allocations or deciding whether they need to work for more years.

For plan sponsors, income-focused reporting can provide a way to measure their plans’ successes. Additionally, any number of decisions that plan sponsors need to make–for example, matching policy, default rates, investment options–could be considered with retirement income front and center.

The focus on retirement income is not an entirely new idea. The marketplace has started to recognize this need and is slowly beginning to create statements showing estimates for income replacement. However, there are currently no standards to guide how these projections are calculated.

The proposed legislation would require the Department of Labor to publish general assumptions plan sponsors or providers could use to create projections for income replacement. Consistency across the industry is critical so participants get a true and accurate gauge on their retirement readiness.

Russell has been presenting on retirement income for several years, and more information can be found in The Retirement Solution: The Reinvention of Defined Contribution, co-authored by Russell’s Don Ezra and Bob Collie with Aon Consulting’s Matthew X. Smith.

Share

Infomercials, billboards, radio advertisements and SPAM email all may lead you to believe that gold is the place to invest. Have you heard of gold parties? Essentially, the host invites friends to a party at their home to sell any unused gold jewelry, coins, fillings, etc. You name it, if it’s gold, they may pay you for it. This is undoubtedly better than going to a party and feeling obliged to buy overpriced candles, kitchenware, or apparel, because at least you may come home with more cash than when you arrived (just maybe not teeth!).

If you’re hearing about gold parties, it’s often a sign that gold is at or near its high, and not likely a great investment if you believe in the investment tenet “buy low, sell high.” And while gold may play a limited role in a diversified portfolio, you should be cautious about your total exposure.

Some investors, who are still concerned about the global economy, might seek the perceived comfort of hard assets like gold. Rather than buying bars or coins, these investors may find it’s better to add it to their diversified portfolio as part of an investment in commodities—a broader product group that includes gold. Keep in mind that commodities, like all investments, carry some level of risk. Futures and options trading is inherently complex and risky and isn’t for everyone. As always, this blog is not meant to provide investment advice and before making any investment decisions you should contact your financial, legal or tax advisor for guidance.

Share

Studies conducted by Russell Investments in 2004 and 2008/9 looked at how much money was paid on a typical institutional foreign exchange trade. The conclusion? Most institutions paid far more than most estimates of what they should have been paying for an average trade of that type.

So what can be done about this?

First, institutions can simply announce that there will be a review of foreign exchange fees on a regular basis. There are three areas to focus for a review–execution quality, outsourcing process and conflict management.

• Execution quality is exactly like it sounds–how well did the investment manager execute the trade? Did they do things like keep track of the date and time that the trade took place?
• Outsourcing process considers whether an investment manager has chosen simply to direct all FX trades to a single counterparty or whether that manager has considered multiple counterparties so that the selection process is competitive.
• Conflict management involves asking for a full disclosure of the potential conflicts of interest among the parties involved in the transaction.

While a review process may sound easy, the devil is in the detail. Foreign exchange trading is complex and transparency is often lacking. For many institutional investors, directing all FX trades to a specialist FX agent may make more sense. For a fee, a third-party agent can shop around for the best deal for each set of FX trades. Of course, any fees paid to a third-party must also be weighed against your transaction cost savings.

In today’s tough economy, unacceptably high foreign exchange trading fees can no longer be tolerated. We believe it’s time for institutional investors to seize control.

Share

Those brinks were real then, and risks of revisiting them persist still, although the risk of the double-dip recession diminishes the more pavement stripes we put in the rear-view mirror. Indeed experience for most investors going back a year and a half feels a lot like a midnight trip in your first car through a terribly dangerous neighborhood: you drive with your fingers crossed on the wheel, hoping not to break down, at least not here, not now! It’s not until you are well clear of the neighborhood that you relax and breathe a sigh of relief.

Well it’s too early to breathe sighs of relief for averting the double dip scenario. I’ve recently been reminded by our market strategist consultant, Randy Lert, that, “the world economy, and the U.S. as a constituent of the world economy, has fundamentally stabilized, especially inventory corrections after dramatic production shut-downs. So the question is less what happens in March of 2010 than what will happen in March of 2011. Why? Because that is when the various remedies – Fed easing, phase-outs of government stimulus and credit packages, and the first time home buyer’s credit – will have run their course.

But despite the worries over the double-dip, can we say it’s a vastly improved landscape compared to a year ago? The quarter closed with the uplifting news about improving employment: The U.S. reported 162,000 new jobs created in the month of March, though a big chunk of them were temporary Census workers. Still, this was enough to support a statement from former Chairman of the Federal Reserve Paul Volker that the U.S. economy may be reaching “breakthrough velocity,” an image that any of us who remember the first Willy Wonka film might process with equal doses of thrill and horror. But despite signs of improvement, 77% of managers surveyed in Russell’s 1Q2010 Investment Manager Outlook expect an 8%+ unemployment rate at the end of 2011. Read the Investment Manager Outlook survey on Russell.com.

Share

Now that both of these predictions seem to have been realized on schedule, it is time to assess what the recession has wrought. The good news is that jobs growth has now resumed, but the bad news is that a recession followed by a jobless recovery results in a permanent output loss.

Most post-war recessions have historically been followed by a period of above-trend, snap-back growth that made up for much of the output loss accrued during the recession. This measure of output loss includes the actual decline in GDP and the shortfall from where the economy would be if GDP growth had remained at a constant trend rate of 3 percent.

Russell’s current projections of GDP growth for the Blue Chip forecasting panel suggest that, despite the severe recession, there will be little snap-back growth ahead. If these forecasts are realized (and they don’t differ significantly from the Blue Chip consensus forecasts), the permanent output loss associated with this recession will be a whopping 6.7 percent. Of course, forecasting is inherently uncertain and the actual figures could be lower or higher, but this level of permanent output loss will have powerful implications for the U.S. economy.

We can contrast this output loss with the 1981-1982 recession, which was the only other post-war recession in which the unemployment rate hit 10 percent. Following the end of the 1981-1982 recession, the economy reeled off seven quarters in which GDP growth averaged almost 7 percent at an annual rate. The strong recovery effectively negated much of the previous shortfall such that the permanent output loss associated with the recession was only 1.4 percent.

One clear consequence of a permanent output loss of 6.7 percent is that the tax base will be about 7 percent smaller. Thus federal government spending will eventually have to retrench to match the smaller tax base, although one would expect some tax rate increases along the way.

The government deficits resulting from the recession and its aftermath will also mean that the federal government will have less borrowing capacity to bail out Social Security and Medicare when both programs exhaust their trust funds. As a result of the decrease in borrowing capacity, I expect that the mix between benefit cuts and federal bailout money to consolidate financing of these two programs will shift toward benefit cuts.

There is never a good time to have a recession, much less one that brings a significant permanent output loss. Nevertheless, the timing of this 6.7 percent output loss is especially bad because it leaves us with large structural budget deficits in the decade in which we were supposed to prepare for the en masse retirement of the baby boomers.

Share

In response, the U.S. government promised quick and significant changes to protect investors and restore confidence in financial institutions. That promise is yet to be fulfilled, but recent congressional activity and comments from political observers and senior Obama administration officials suggest that may change soon.

In December, the U.S. House of Representatives passed the Wall Street Reform and Consumer Protection Act of 2009. Not to be outdone, the Senate Banking Committee passed the Restoring American Financial Stability Act of 2010. Both financial regulatory (or “FinReg”) reform bills involve significant and wide-ranging reform to the U.S. financial industry, extending regulators’ reach deep into the financial system to prevent a repeat of recent history.

Both bills give the Federal Deposit Insurance Corporation (FDIC) the ability to put large, non-bank firms into a liquidation process to avert systemic risk to the financial stability of the country. A consumer protection agency is also envisioned under each piece of legislation, which would be charged with shielding consumers from unfair and deceptive financial products and practices involved in mortgages, credit cards and consumer credit reports.

The magnitude and complexity of both bills suggest it may be difficult to pass the Senate version and then reconcile both bills before presenting a final bill to the president for signature. Lobbying by financial firms is likely to be fierce, and both parties seem to view the consumer protection agency as the cornerstone of the legislation – it’s arguably the most visible aspect of reform to the public and the part that’s likely to drive passage of the bill.

Momentum seems to be on the side of the regulators. The health care victory appears to have energized reformers, and one has to wonder – on the heels of such extensive reform, will opposition to the FinReg bill be milder than perhaps expected?

Share

As you would expect, different segments of the market perform better or worse than others, and therefore some indexes are easier or harder to beat than others. Indexes that are easier to beat are metaphorically known as “slow rabbits” and there is a strong inclination to use these as benchmarks for active management. Indexes that are harder to beat are considered “fast rabbits” and it can be difficult to convince active managers to use them.

The ETF industry has spawned a ravenous demand for new index products, covering a vast range of markets and segments. The bulk of ETF assets are in products tied to core indexes that measure broad asset classes such as equity and fixed income, and to a lesser extent more specific, targeted areas such as economic sectors or specialized strategies. Increasingly, investors are presented with ETFs tied to indexes that “outperform” other indexes, despite the fact that by definition an index shouldn’t be designed to “outperform” anything, it should be an objective measure of a particular market, segment, or strategy.

As an organization dedicated to providing better tools to investors, it does present a quandary; indexes that are to be used as benchmarks for active management will be more readily adopted if they are easier to beat, but indexes that are to be used as the basis for investible products are increasingly expected to provide exceptional performance. It’s enough to make an index provider a bit schizophrenic – should we be building “fast” rabbits or “slow” rabbits?

Our answer: Build “fair” rabbits, that is, indexes that are objective representations of the markets they are designed to measure. We believe investors need to have a clear idea of the results they can achieve at low cost, and also have an unbiased measure for comparing the outcomes of their active decisions. If “indexes” are designed instead to outperform a passive alternative, should they be labeled as active strategies and used accordingly?

Share

By now it is abundantly clear that the bubble in housing prices was damaging to the economy – but are all bubbles harmful enough that policymakers should act to prevent them?

After all, the bursting of the dot-com bubble was associated with only a very mild recession in 2001 and it is not even clear whether the dot-com bust was a principal cause of the recession. In his April 7 testimony, Alan Greenspan declared that “Regulators cannot use the ‘bully pulpit’ to manage asset prices, and they cannot calibrate regulation and supervision in response to movements in asset prices.”

Asset price bubbles are generally considered threats to our economic well-being. But is there any asset that can experience bubbles without harming the broader economy? That is, can some asset play the role of a “foil” for speculators and worry warts? In theater, a foil is a character who displays the opposite traits of another character, and is therefore useful in making the latter stand out more clearly.

How about gold, which does not have much of a productive role in the economy outside of jewelry production? Some investors concerned with the possibility of inflation due to the Federal Reserve’s $2.3 trillion balance sheet have helped bid up the price of gold – traditionally considered an inflation hedge – to about $1,150 per ounce as of April 7, 2010. Thus, one could claim that current monetary policy is engendering a bubble in the price of gold.

If so, is such a bubble harmful? I would argue the contrary – the financial system needs an asset whose price can rise and fall significantly as an outlet for the ebb and flow of inflation concerns without distorting relative prices of productive assets.

A bubble in the price of gold is not trouble. If gold did not exist as a speculative asset, the financial markets would have had to invent it!

Source: “Live Blogging Greenspan’s Testimony Before Financial Crisis Commission.” Wall Street Journal Blogs.

Share

1. Describe the most efficient way to manage an investment portfolio subject to the investor’s tolerance for placing wealth at risk.
2. Describe the most efficient way to manage a retiree’s portfolio to provide sustainable cash flows for life, subject to the investor’s tolerance for the risk of outliving the money in the portfolio.

I would expect that responses to the first item will almost invariably embrace a common set of tenets from modern portfolio theory (the famous and scientifically rigorous investment framework that earned Dr. Harry Markowitz a Nobel Prize). Yet I suspect that responses to the second item will be highly varied.

Does anyone find it troubling that generally accepted principles exist for addressing the first investment problem, but not the second? I sure do. After all, this is one of the most important problems in the field of economics facing the world today.

With so many theories floating around about spending down or “decumulating” a retirement nest egg, how are people to know which of these are based on sound economics and which are not? The complexity of the problem is made clear in considering questions such as:

• Should retirees have moderately high exposures to risky assets to provide the growth necessary to fund a potentially lengthy retirement horizon? Or is this just wishful thinking that will work well for many cohorts of retirees, but fail miserably for others?
• Is it wise to plan a spending budget that will maintain your standard of living in retirement until some very advanced age, even though the chance of living that long is low? Doing so suggests a very low tolerance for risk taking, but if that is the case then should the investor’s portfolio be anything but conservative? If so, then under what circumstances?
• Should investors purchase lifetime income guarantees to safeguard a future standard of living? How should decisions be made pertaining to if, when, how much, what type and how many guarantors should be used?

These are all good questions in need of academically rigorous, yet practically implementable, answers. I do not seek to provide answers here, but suggest that a good way to start the search is by establishing a simple set of guiding principles as a compass. The first two principles on my list are:

1. Never risk more than you can afford to lose.
2. Do not buy insurance that you do not need.

When you’re creating your own list, remember that the most important discoveries often start with the simplest of ideas.

Share

During this period of exceptionally low interest rates, the Fed’s balance sheet has ballooned to about $2.3 trillion – roughly triple its size prior to the financial market turbulence in 2007.

One concern among investors now is a potential conflict between the date by which the Fed should start reining in its balance sheet to prevent excess credit creation and inflation expectations and the date at which the Fed could sell a good portion of its mortgage-backed securities holdings without sinking the mortgage market.

Some observers worry that the Fed has painted itself into a corner by acquiring relatively illiquid assets to combat a temporary financial crisis. However, this line of reasoning assumes that the only way out for the Fed is to sell its holdings of mortgage-backed securities outright.

In contrast, the Fed wants to convey that it is armed to the teeth with tools to reduce its balance sheet quickly when it chooses to, of which an outright sale of these securities is only one.

The second tool is a factor of the Treasury’s recent resuscitation of its Supplementary Financing Program (SPF), whereby it stands ready to issue $200 billion in Treasury bills beyond its current financing needs. The plan calls for the Treasury to deposit the proceeds from such an issuance with the Fed, and for the Fed to buy nothing with the deposited funds. This would reduce the excess reserves in the banking system by roughly 20 percent in one fell swoop.

Third, the Fed could lock up excess reserves by offering an attractive interest rate to banks on term deposits at the Fed. This step wouldn’t actually reduce the size of the Fed’s balance sheet but would reduce the amount that banks could lend.

And lastly, the Fed has begun a pilot program through which it could enter into reverse repurchase agreements directly with money-market funds. If the Fed offers to sell a mortgage-backed security and buy it back in 90 days at a pre-specified price, that agreement looks a lot like a Treasury bill and should pay slightly more interest.

The interesting paradox is that the more the Fed can convince everyone of the efficacy of these four tools, the longer they can afford to wait before actually shrinking the degree of monetary stimulus provided.

If things are working out the way the Fed wants, it seems we can expect a lot of preening about this powerful arsenal of tools but little action until the current economic expansion has firm legs underneath it. Interest rate hikes wouldn’t be expected to follow until the Federal Reserve has reduced the size of its balance sheet to the point where there is enough of a bank reserves “shortage” to warrant an above-zero interest rate on interbank lending.

Share

The answer really depends on the situation and attitude of the individual investor. Guaranteed products range from conventional life insurance and annuities offered by insurance companies to innovative new products like variable annuities offering a guaranteed minimum withdrawal benefit for life, or “principal protected” structured products that allow investors to participate in up equity markets with a guaranteed floor when markets go down.

What these products have in common is a guaranteed financial outcome – something that certainly might appeal to many investors after a period of significant market volatility. The guarantee is backed by the balance sheet of a bank or insurance company.

Issuers of guaranteed products maintain risk control procedures to protect their balance sheets and satisfy regulators, often utilizing hedging strategies that involve options, swaps and other derivative securities as well as complex dynamic asset allocation modeling.

These risk control measures are essential to guaranteed products, but they don’t typically come cheap. The hedges usually involve the purchase or replication of options that are very expensive today due to low interest rates and high market volatility. The complex dynamic asset allocation models must be built and maintained and, of course, the issuers of the guarantees must be compensated for bearing the remaining risk they cannot hedge away.

There is also a more “hidden” opportunity cost. The need for proper risk control may actually cause guaranteed product providers to shy away from innovative new investment ideas because their risk may not be easily evaluated and priced into existing models and risk control processes.

These guarantees are really just insurance against bad outcomes. As in evaluating any insurance purchase, investors need to consider both the cost of the insurance and the personal consequences of experiencing the bad outcome. This is pretty straightforward if you are deciding about homeowners or auto insurance, but more complicated when considering guaranteed products.

One method of comparison for guaranteed products is to project a number of “good” and “bad” market scenarios, and see how the guaranteed product compares to alternative approaches without guarantees. Regardless of the method, investors need to understand how the guaranteed product works and what it costs, and this does take some knowledge and effort. A lot of investors can do this analysis themselves, and any financial advisor or seller of these products should be able to provide a comprehensible analysis as well.

Guaranteed products may be right for you – just make sure you know what you are buying and how much it really costs.

Share

I moderated a panel at the conference titled “The Changing Role and Definition of a Fiduciary” which underscored the connection between sound decision-making by plan sponsors and the ability of DC plans to meet their goal of providing plan participants with an income during retirement.

This conversation confirmed that DC fiduciaries face many difficult challenges. Plan sponsors must tackle tough issues including manager and fund selection, monitoring, annuities and participant advice. Additional layers of complexity result from the fact that there are many additional stakeholders, most notably individual plan participants and outside DC financial professionals.

Individual plan participants are key decision makers, so fiduciaries must structure their plans with that in mind. To do so, DC plans need to strengthen participant understanding of basic investment principles as well as understand human behavior. Intensifying the complexity of this task to another degree, for each individual there can be a wide set of associated variables to consider including varying levels of risk tolerance, differing investment objectives, and discrepancies in the level of knowledge about or general interest in investments.

The Pension Protection Act helped provide some guidance and empowerment to the plan sponsor to make decisions on behalf and in the best interest of individual plan participants, as is done in default enrollment. Questions about legal protections still remain among DC plan sponsors, however, as their roles require selection of appropriate qualified default investment alternatives, including target date funds, and determination of the appropriate levels of risk for each associated glidepath for target date portfolios.

Plan sponsors are also responsible for selecting a host of qualified outside parties (investment managers, consultants, advice providers, record keepers, etc.) to help operate the plan. The resulting implication for the plan sponsor is that they must understand and monitor the execution of fiduciary duties by these numerous other providers.

The good news for plan sponsors is that they can partner with experts to help them fulfill some of these fiduciary duties. An effective partner can provide plan-level advice, participant advice, or even be asked to take on decision-making authority on behalf of the plan sponsor, although the plan sponsor still retains primary fiduciary responsibility even in this case.

Ultimately, conversation and a true understanding among all players about roles and obligations is paramount. If plan sponsors understand participant needs, equip them with necessary information and resources, and always exercise thoughtful, sound due diligence in decision-making, they are generally believed to be acting as responsible fiduciaries.

As DC continues to evolve, fiduciaries should stay on top of industry developments and look for new ways to augment and document their due diligence processes to help ensure that there are no gaps. Additionally, they should ensure that all other outside parties are held to the same fiduciary standards as they hold for themselves and that plan participants have access to investment information that will help them participate in the investment process. Taking these steps should ultimately lead to better outcomes for DC plan participants.

Share

This blog post aims to provide you with a little more information regarding types of bonds and is not meant to provide investment advice. To ensure that you’re making a good decision for you, contact your financial, legal, or tax advisor for guidance before investing. As with all investments, it’s important to have a mechanism to monitor them. Consider all of the risks, such as the likelihood of default or that the market may be unwilling to pay the price you’d like when you choose to sell.

Some bonds are more sensitive to changes in interest rates, including mortgage-backed securities. When rates fall, some homeowners refinance into a lower rate mortgage. This means they pay off their current mortgage early, resulting in a “pre-payment.” The prepayment can be problematic for the mortgage investor because while they got their money back (a good thing), they now may need to think about finding another investment in the lower interest rate environment.

On the other side of the interest rate sensitivity spectrum, you’ll find securities like high yield corporate bonds. Instead of being driven by interest rate changes, price changes of high yield bonds are more likely driven by events specific to the firm, such as losing a competitive position relative to a peer, or weak financial results. Note that this type of bond has a higher risk of default than many other bonds.

With this in mind, what can you do if you’re thinking about bond investing? One possible strategy could be to own fewer mortgages or own mortgages that are less likely to “pre-pay” such as mortgages with an interest rate lower than current interest rates. You could also own securities less sensitive to interest rate changes.

Two plus two is always four so when rates increase, bond prices drop. But, keep in mind that active management seeks to add value regardless of the market environment. One of the ways active managers do this is by changing the interest rate sensitivity within their portfolios, depending on their view of not just the direction of the rate change, but also how quickly rates will change.

Share

There is seemingly no end to the levels of abstraction in the financial markets. Trading futures once meant trading commodities. Futures contracts were just one step removed from things you could put your foot on; contracts good for delivery in dusty warehouses filled with copper ingots, grease wool, or sacks of unroasted Arabica beans.

The great wave of change came out of Chicago in the early 1970s with the realization that futures exchanges did not fundamentally trade things, like oil or soybeans. Rather they traded risk. And brother there’s a whole world of risk out there. From currencies to interest rates to weather, instruments for redistributing the risk of an uncertain future have since mushroomed.

So now we’ve come to Hollywood. With director James Cameron’s estimated $460 million gamble on the production and release of Avatar, one can see where the financial backers could have used some risk diffusion. With a greater dispersion of risk, it is possible that more risks will be taken. More risks taken might mean more willingness to stray from formula in film.

So what is next? One potential is video games. Film industry revenues were eclipsed by video game revenues years ago. In 2008 game revenues were $21.4 billion, compared to the film industry’s $9.79 billion for that year. Why not distribute the risk participation of game development via a video game exchange? Beyond the nuisance of confused skateboarders showing up on the floor to swap games, the game exchange could help increase overall investment by spreading the risks involved.

It seems like this role for a futures market – risk distribution – is often missed by pundits and politicians when given a microphone on the subject. Markets are at times compared to casinos, speculators are compared to saboteurs, and proposals are often made that would leave the market less functional by limiting participation.

The “natural” risks of institutional investors – be they interest rate risks or risks of under- or over-exposure to a market or currency – are not likely to be offset by exposure to the next Harry Potter film’s box office receipts. In our opinion, for the proposed “Hollywood” market to work, it will need speculators.

Share

As former CEO Andrew Doman commented in a previous post, there may be no better way for the financial services industry to focus on innovation than in “rethinking” risk. I recently wrote a paper exploring how the very modeling tools developed to help investors wade through the complexities of financial planning can actually “mismeasure” risk if you’re not careful.

Many financial planning tools define risk as the probability that the plan fails – or the individual runs out of money. That definition of risk is just plain wrong. Risk is really the product of two factors: probability of failure and magnitude of failure.

The fact is, an event with high probability and low magnitude may have the same overall risk exposure as an event with low probability and high magnitude – neither factor is more “important” than the other. But by largely ignoring the possible magnitude of that failure, the full extent of risk goes unmeasured. When planning for your future, does it really makes sense to consider the probability of an income shortfall but not how big or small it might be? No, of course not.

The issue of proper risk measurement is vitally important. Getting it wrong might be dangerous to your wealth. Think of it this way: if all risks – whether they be spending shortfalls or speeding tickets – are treated the same regardless of magnitude, then aggressive actions (higher equity allocations, higher driving speeds) will not appear as “risky” as if the magnitude of the consequences are considered.

In financial planning, this thinking might lead an investor to build a portfolio erring on the side of being overly aggressive. And when planning for retirement, being too aggressive in your investment portfolio may have less than desirable outcomes…

This is not to say that planning tools that measure probabilities should be scrapped. A probability statistic may be useful as a quick check on whether a spending plan is reasonable, but it is simply inadequate when it comes to actual decision making with investment portfolios.

Until the industry sees the introduction of modeling tools that fully consider the magnitude of risk as well as the probability, one might approach these tools with a “buyer beware” frame of mind.

Share

Is globalization a good thing? From an objective economic standpoint, globalization it seems to make sense. Geographic barriers are lowered, goods and services can more freely flow across borders, and the inputs to production (capital, labor, and resources) become cheaper and more readily available. Despite some of the localized disruption that creates angst toward globalization (think offshoring of jobs from one country or region to another) over time globalization can lead to a beneficial, if not inevitable, outcome.

However, the recent financial market crisis and renewed focus on investment risk, has revealed a potential downside to globalization. In a world where markets and asset classes are increasingly correlated, where do investors look for diversification?

As investors, we are taught that diversification is one of the most powerful steps we can take toward managing risk. If I invest in two assets that are not perfectly correlated, I know that the risk of the assets combined is less than the risk of any one of those assets. In theory, if I combine a variety of assets from different markets or asset classes or industries I should be able to create a portfolio that is shielded to some degree from the risk of any one asset.

But what happens to risk management when markets are so tightly coupled that asset classes like stocks, bonds, and commodities experience simultaneous drops in value? What happens when equity markets around the world all decline in tandem as they did in 2008?

The topic at the forefront of many investors’ minds right now is risk, and there definitely seems to be discussions that we need to find a way to manage it. Our conversation about risk needs to account for the fact that in an increasingly globalized economy, diversification will be even more difficult to find.

Share

Some investors chose to move to cash investments hoping to avoid future losses. Some tried to time the markets. But market timing requires two decisions—the first is when to sell, but often more important is the second decision of when to get back in. Admittedly, knowing when to get back into the market can be a much more difficult decision than pulling out.

In general you’re likely better off sticking with your investment strategy rather than guessing when to buy and sell. Hindsight is always 20/20, and just because it may seem possible to time the market, it doesn’t mean it can be done successfully.

Historically, large market rallies follow extreme downturns. The challenge is predicting the lows and the resulting highs. By the time investors who flee the markets see a pattern of recovery and reinvest, they’ve often missed out on the initial gains. By staying invested over the long haul, history has shown that you should be positioned to reap the gains of upturns when they come. As others have said, this blog is not meant to provide investment advice and before making any investment decisions you should contact your financial, legal or tax advisor for guidance.

For historical information, learn more about the impact of staying the course in this hypothetical example that compares two portfolios–one that was invested in a 60/40 index strategy and one that went to 100% cash.

Share